Why Inflation is Dead: Two Revealing Charts of Consumer Credit Trends

Late last week, our good friend and fellow deflationist Carson sent over a link from Mish Shedlock's blog, reporting a sharp annualized decrease in consumer and revolving credit.

I just plotted the Fed's historical data since 1978 (which I chose because there was a single quarter anomaly in 1977 that I didn't feel like dealing with).

First, we see that consumer credit, as of February 2010, is decreasing at an annual rate of 5.5%:

Consumer credit, after trending positive YOY in January, is once again heading south.

Next we look at revolving credit, where the data is even uglier, both in current and historical terms. Revolving credit decreased at an annual rate of 13%:

Will this debt ever be paid off?

The sharp decline in revolving credit, which is defined as credit that does not have a fixed number of payments or payment schedule (think credit cards), would appear to support the debt deflation argument (of Robert Prechter, most notably) that much of the current debt outstanding is going to go unpaid.

So while the government has engaged in quantitative easing to "ease" the issuing of its own debt, it has not yet offered to print up some greenbacks to pay off the debt of American citizens.

Thus far, it appears Americans are still choking on their massive loads of accumulated debt, unwilling to take on more credit, no matter what the Fed does.

It will be interesting to see if the Fed is able to reverse these trends.

Why Marc Faber Is Predicting A Large Correction Right About...Now

About a month ago, Marc Faber told Bloomberg that we could easily see a correction of 20% if the S&P topped 1150 and approached 1200.

Well, it seems like we're just about there, so we'll see how Faber's near term musings fare in the weeks ahead.

You can check out a video of Faber's Bloomberg interview here.

Some other thoughts from Faber:

• He thinks the Euro is very oversold, and can rally to 1.40 before going lower

• Doesn't see anything much good about the Euro, or the Dollar, for that matter

• Debt monetization is inevitable in the long run

• He likes precious metals and Asian currencies - says "most currencies are sick"

• Better to be in stocks than bonds over the next few years, because he expects increasing inflation

Faber's book Tomorrow's Gold is excellent by the way - if you haven't read it, and you are a Faber fan, I'd definitely recommend you pick up a copy.

Interestingly Faber was a deflationist when he wrote the book almost 10 years ago, and has since flipped to the inflation camp, because he believes that sovereign printing presses will overwhelm broader deflationary forces.

Further reading: Why Marc Faber sees no way around US inflation.

Why The Federal Deficit Is In Even Worse Shape Than You Think

If there was any question before that the federal deficit was completely out of control and unsustainable, the successful passing of the "free healthcare for all" plan should completely seal the deal!

As you probably recall, the out-of-control debt spiral faced by our government sparked some interesting conversation at our local Casey phyle meeting about the safety, or lack thereof, of our retirement savings.

That conversation was originally inspired by a fine piece of analysis that Bud Conrad, Casey's Chief Economist, put together for The Casey Report. They've graciously given us permission to republish Bud's piece here, so read on to learn just how bad the federal deficit is. Believe it or not, it's probably worse than you think!

***

Battle for the Budget

By Bud Conrad, Editor, The Casey Report

Recently the Congressional Budget Office (CBO) published its scoring of President Obama's budget for the next 10 years. It shows a budget deficit of $9.8 trillion. That is just shy of $4 trillion worse than the CBO’s baseline budget, a budget that includes only the laws as currently enacted, with no estimates of any new programs lawmakers may add that worsen future projections.

That our budget is out of control is no surprise, but the charts I present here should provide some perspective of just how dangerous this set of budget estimates could turn out to be. The first chart below shows the amount of red ink in each year for the two CBO estimates.

To get a visual interpretation of just how big these budget deficits have become, I plotted the long-term history, then tacked on the CBO evaluation of the president's proposal. Knowing the propensity of governments to spend more than they promise makes one question if the large improvement shown in the dotted line will actually occur. Even if nothing changes, however, the results look like they could be very damaging for other aspects of our economy.

One aspect of the CBO projections that is difficult to defend is the expectation that inflation will stay incredibly low. In the next chart, I present the same sort of long-term history, coupled with the projection, for the Consumer Price Index (CPI).

In the next chart, I put together two of the most important measures: the three-month T-bill interest rate and the deficit expressed as a percentage of the gross domestic product (GDP). Both history and projection are shown.

The most important observation is just how disastrous the current deficit is in the historical context, even after rationalizing it by dividing it by the GDP. I overlaid the two series to show that higher deficits in the past tended to occur along with higher interest rates.

As you can see, we now have a significant anomaly, with the budget deficit at its worst in half a century, while interest rates remain near their lows for the period. A closer look at history shows many divergences, to the point that in the short term these two series tend to bounce in opposite directions. That is probably because when the economy shows weakness, the government expands its spending and collects lower taxes, so the deficit becomes worse. Thus, in the short-term cycle of a few years, these two measures often move in opposite directions.

But the situation we face now is much bigger than anything we've seen since the 1950s. The government bailouts and stimulus are at record levels, and the special actions of the Federal Reserve have driven interest rates close to 0%. It is my expectation that both inflation and interest rates will rise dramatically because of these large deficits.

I also think the projected interest rates are much lower than what I expect the deficit would require. As foreigners and others recognize how seriously indebted the U.S. government is becoming, they will expect higher interest rates to compensate for the debasement of the currency.

The budget analysis goes further in calculating the expected growth of the economy, which ranges from 2 to 4% over the years. Those are not large numbers for real GDP, but there is no expectation of another recession during the decade. If the economy didn't grow, tax revenue would be less, and the budget deficit would be worse.

While interest rates are expected to rise as shown in the chart above, the projections expect that they roll over and stop rising at around 5%. That is contrary to my expectations that they will be much higher, and even perhaps closer to 10%, by the end of the decade. If they are, the cost of funding the outstanding government borrowing escalates rapidly because the increased interest has to be added to the debt so that the debt grows even more.

The problem from the onset of this crisis has been the debt, and that continues to be the case.

Leaving aside the above two adjustments that could make the budget deficit worse, it’s helpful to look at the outcome with the given assumptions and see where it leads. Perhaps the most problematic result is that the debt of the federal government held by the public grows from $7.5 trillion in 2009 to $20 trillion by 2020. Such big numbers are hard to understand, though you can get some sense of things by considering that the government is intending on almost tripling the debt in just 11 years. The ratio of this outstanding debt to the GDP gives a flavor of how dangerous the situation has become. As Ken Rogoff and Carmen Reinhart have indicated in their new book, when we approach 90% government debt of GDP, we have serious potential for a currency crisis. As you can see, we are well on our way to those levels, even without assuming the two adjustments above.

How will the deficit be funded?

The question arises who will service the rising levels of debt. Clearly the taxpayers are on the hook for all these projections, with more to come. So the question becomes whether the tax base can grow fast enough to provide support for servicing the debt. The CBO gave us two series for the tax base. One is Domestic Economic Profits, and the other is Wages and Salaries. The basic assumption is that these are the main revenue streams that can be taxed by the government to fund its expenses. I added these two series together and divided by the GDP to determine if the tax base is growing more rapidly than the economy. Unfortunately, but as expected, the orange line in the above graph shows that the tax base only grows about as fast as the economy itself. That's not surprising, but the contrast to the rapid growth in debt will be a serious source of problems, as the only way the debt can be sustained will be through increasing the tax rates, and probably quite dramatically.

The latest set of budget predictions will probably be wrong, and not just because the assumptions are too optimistic, but because there is a relatively high probability that something will go off track to cause a major shift before the 10 years are completed. Unfortunately we are not preparing ourselves for such problems, and so I would interpret the CBO projections as being far too rosy.

Bud Conrad is the chief economist at Casey Research, and crunching numbers like these is his daily bread. It also enables him, together with the rest of the Casey Report team, to accurately forecast what’s in store for the U.S. economy… a skill that subscribers to The Casey Report have come to highly appreciate. Learn more about what the future holds and how to profit by clicking here.

Ed. Note: As you probably know, I am a longtime Casey Research subscriber and affiliate.

Breakdown of the Fed's Balance Sheet...Wow, it's Not Pretty!

Let's join monetary expert Terry Coxon for a (comically?) detailed look at the Fed's current balance sheet. I'll give you a hint: yikes!

I'd rank Coxon as one of the foremost experts on monetary policy and its effects on the economy. You may recall his name from a classic book he co-authored with the great Harry Browne.

Coxon concludes that inflation will rule the day, because the Fed's hand is being forced. By the way, if you are a Casey Report subscriber, go check the archives for the inflation/debate between Coxon and Bob Prechter. It was fantastic - one of the best things I read in the past 12 months. Something I've reread at least a few times over.

Please read on for some Fed insights from Coxon...

***

The Road to Zimbabwe

By Terry Coxon, Editor, The Casey Report

Sprinkled among all the official talk about efforts to end the current recession, you’ll hear assurances, notably from Federal Reserve Chairman Ben Bernanke, that when the economy does revive, it won’t be allowed to blast off into runaway inflation. The Fed, we’re being promised, will prevent such a launch by reabsorbing the hundreds of billions of dollars of excess liquidity it recently created to halt the credit crisis.

Delivering on those assurances won’t be easy. There is no reliable, real-time guide to how much cash the economy needs, so deciding when to drain excess reserves from the banking system (by selling off T-bills or other Fed assets) and judging how rapidly to do the draining will be largely guesswork. And the consequences of guessing wrong will be unforgiving. Drain too fast, and the recovery stalls. Drain too slowly and price inflation comes charging out of the chute.

Figuring out how much cash is just right for the economy has always been the Fed’s central puzzle. And until late last year, coming up with a workably close answer, day after day, was the only thing the Fed really needed to focus on. Executing its decisions was easy. Since it could create money, the Fed had unlimited power to expand liquidity by buying Treasury securities (or anything else). And since it owned a mountain of Treasuries built up from past purchases ($480 billion as of last September), it had the power to drain liquidity by selling from its holdings.

That Was Then…

That picture of the Fed’s power may be changing. Even if the Fed were to show unprecedented skill (or enjoy unprecedented good luck) in judging when to drain the excess liquidity that today is an inflationary time bomb, it might find itself without the wherewithal to do so. We can estimate how close the Federal Reserve is to such a trap by examining its assets and seeing how they compare with the excess “reserves” held by commercial banks. It is the excess reserves that the Fed will need to soak up at some point to prevent the time bomb from detonating.

I put “reserves” in quotes because they aren’t what you might think they are. They’re not money that banks put away as a provision for bad loans or for handling a surge in withdrawals. So-called reserves are more like the transmission fluid running through the machinery that the Federal Reserve uses to control the size of the economy's money supply.

If a bank wants to issue demand deposits to its customers, by law and Federal Reserve regulation, the bank must hold “reserves” equal to 10% of those deposits. Only two things count as reserves – cash in a bank’s vault and deposits that a bank holds at a Federal Reserve Bank. The Fed can easily increase the total reserves available to banks by buying T-bills or other assets, and in ordinary circumstances it can easily drain reserves from banks by selling T-bills or something else. By altering the amount of reserves available to banks, the Fed alters their ability to maintain demand deposits for their customers, which in turn increases or decreases the M1 money supply.

The last time the Federal Reserve balance sheet looked somewhat normal (by historical standards) was in September of last year. Here is the asset picture from last fall, summarized.

On the same date last September, the reserves of commercial banks and other depository institutions exceeded the legally required amounts by $22 billion. If the Fed had wanted to absorb those excess reserves, to keep them from feeding an expansion in the money supply, it would have had the means to do so – and by a wide margin. It could have done it in an instant by selling $22 billion of its $480 billion of Treasury securities. Or it could have done it overnight by refraining from rolling over $22 billion of its $127 billion of repurchase agreements. Between those two asset sources, the Fed had 28 times the power needed to mop up all excess reserves.

The Fed was more than well prepared. But it is noteworthy that if you examine the rest of the Fed’s assets, you’ll find that none of them would have been available for the job of smoothly absorbing excess reserves. In principle, the Fed had the option of refraining from renewing $22 billion of term auction credit – but that would have threatened the banks that were relying on the credit.

This Is Now…

The current picture of the Fed’s ability to absorb excess reserves is far different from last September, as revealed by the asset side of the Fed’s balance sheet at the end of July.

Notice that the asset total has more than doubled since last September, from $924 billion to $2,041 billion. The Fed engineered most of that increase by buying assets (most notably mortgaged-backed securities of dubious value) and lending to distressed institutions it considered too big to fail. It paid for all its new assets with brand-new dollars, which added dramatically to bank reserves and hence to inflation-threatening excess reserves.

On the same date, July 22, excess reserves were $744 billion.

That is a big and dangerous number. When the current recession begins to ease, short-term interest rates will rise from their current near-zero levels. Banks will then be in a hurry to lend or invest their excess reserves. Things would move fast. If the Fed did nothing, the big unloading of excess reserves might take just a few months.

Each dollar of excess reserves that banks lend or invest translates into about a $1.65 increase in the M1 money supply. So the $774 billion in excess reserves would translate into about a $1.27 trillion increase in M1 – which, in percentage terms, would be a springboard leap upward for the money supply, over the course of just a few months, of 76%. That would quickly produce catastrophic rates of price inflation – not as bad as Zimbabwe, for sure, but worse than a bad year for Bolivia or for other countries where llama herding is a key industry.

Total Fed holdings of assets it could use to mop up that $744 billion of excess reserves and avoid such a catastrophe -- Treasury securities, agency securities, and repurchase agreements – rose modestly, to $793 billion, since last September. Thus today the Fed still has enough – but now just barely enough – easy-to-use assets to absorb the dangerous excess reserves.

So the Federal Reserve isn’t quite in a trap yet. It will still need extraordinary skill, rare good luck, clairvoyance, ESP, championship-level Ouija skills and a bat-like capacity to navigate in the dark to deploy its resources at just the right time and at just the right pace to avoid setting off a damaging, 1970s-style inflation. But it does have the resources – unless the problem of excess reserves gets worse.

Credit Crisis Phase II

What might add to the problem of excess reserves and make it unmanageable is Phase II of the Credit Crisis.

Today Phase II is just a maybe, a possible next round of bank troubles coming from bad commercial real estate loans and the resetting of interest rates on a bumper crop of option-ARM home mortgages. If Phase II arrives, the Federal Reserve will be forced to buy up another $1 trillion or so of toxic paper to once again haul the banking system back from the edge of collapse.

That would increase banks’ excess reserves by another $1 trillion without doing much to increase the Fed’s ability to eventually reabsorb the additional reserves. In that case the Fed would be in real danger of losing control over the money supply and getting caught in a hyperinflation trap.

The reckoning would come when the economy began to recover from the recession. At that point, dealing with excess reserves to prevent the money supply from rapidly doubling would be a matter of urgency. Lacking assets it could sell to absorb excess reserves, the Fed would have only one weapon left -- the interest rate it pays on those reserves. By setting the rate high enough, it could discourage banks from lending the reserves and adding to the money supply.

But life would start to get very complicated for the average Fed governor. The interest rate that would make this work, for a while, would be the rate on Fed funds. But that rate would be rising with an economic recovery, and the Federal Reserve would be paying the rate on perhaps $2 trillion.

Where would the Fed get the money to pay its interest bill? Its primary source of income would be the pile of toxic paper it has been accumulating in trying to rescue the banking system. So the Federal Reserve would find itself in exactly the same position that ill-run commercial banks have been in since last fall -- living on overnight credit and hoping that a portfolio of bad loans will somehow generate enough cash to cover the interest cost. Of course, if the Fed's portfolio of troubled loans failed to produce enough cash, the Fed, unlike a commercial bank, would have recourse to buying time by printing still more money -- but that would add further to bank reserves. You can see where the road leads. It leads to Zimbabwe.

Ed Note: Terry Coxon believes that runaway inflation is already baked in the cake, and protecting your assets from devaluation should be your number one priority. The Casey Report - a monthly must read for me - focuses on the big, emerging trends in the economy and markets, and how to profit from them, even in times of crisis. One of the developments they keep their eyes on is the coming rise in interest rates – a virtual inevitability – and the money-making opportunities it will present to our subscribers. Learn more here.

Why the FDIC Will Soon Require Hundreds of Billions in Bailout Funds...At Least!

Despite the self congratulatory nature of the financial media in the recent weeks and months, I remain highly skeptical that the worst is indeed behind us. Down in the trenches of daily economic life, I can't find any noticable signs of improvement. In fact, the only thing that seems to have changed is a sharp 50% rally in the major US indices, which has buoyed bullishness towards the stock market.

If my suspicions are correct, then one house of cards that's sure to be blown over during the first gust of economic bad news is the FDIC. It's chances of funding it's insurance obligations is laughable to say the least. And because it's not politically palatable to allow the FDIC to default on these obligations, this means more bailouts are on the way - likely to the tune of hundreds of billions of dollars.

To explore this theme in more detail, we'll turn it over to our good friend Bud Conrad from Casey Research. Bud, a frequent guest columnist, cranks out top notch investment analysis that's "too heavy" for mainstream finance from his home in Silicon Valley. I am a subscriber of Bud's, and also am fortunate enough to be a part of the local SV investment group that Casey Research organizes and Bud participates in.

Read on for Bud's insightful piece...

***

The FDIC Is in Trouble

By Bud Conrad, Editor, The Casey Report

As we all know, the Federal Deposit Insurance Corporation (FDIC) guarantees depositors that they’ll get their money back if a bank fails, at least up to a certain amount. To fund its operations, the FDIC collects small fees from the banks that are held in reserve for the purpose of taking over troubled banks and paying off depositors.

Since the Great Depression, a period marked by widespread runs on banks, the FDIC has done a good job of fulfilling its mandate. So how are they doing in this crisis?

In a nutshell, they are in trouble.

The FDIC insures 8,246 institutions, with $13.5 trillion in assets. Not all of them are going bankrupt, of course. Yet as of late July, a disturbing 64 banks had gone belly up this year – the most since 1992 – costing the FDIC $12.5 billion. At the end of Q1, the agency was already asking for emergency funding.

And worse, much worse, is likely yet to come. The following chart shows the total assets on the books of the FDIC’s list of 305 troubled banks. The list doesn’t include the biggest banks that are considered too big to fail, as they are being separately supported with bailouts. By contrast, if the banks on this list fail, the FDIC is on the hook to have to step in and take them over and, of course, make depositors whole.

Other measures of how serious the losses at banks are becoming can be seen in the chart below, which shows charge-offs and non-current loans at all banks. You can see that the Net Charge-offs remain stubbornly high, with banks charging off almost $40 billion in bad loans in the last two quarters alone. And the number of non-current loans – loans where payments are not being kept up – is soaring.

Together, these measures indicate the potential for more big failures and more big bailouts coming down the pike.

About Those Reserves…

Into the battle against bank insolvency the Fed brings a level of reserves that can best be described as paper-thin. From almost $60 billion last fall, the FDIC’s reserves have been drawn down to only about $13 billion today, a 16-year low. A quick look at the FDIC’s own data shows us how inadequate those reserves are compared to the deposits they are now insuring.

The chart below says it all:

As you can see, the Federal Deposit Insurance Corporation currently covers each dollar on deposit with a trivial 2/10ths of a penny.

And even that understates the seriousness of the situation: the $4.8 trillion in deposits the FDIC is providing coverage on doesn’t include the expansion that now extends insurance coverage from $100,000 to $250,000 for normal bank accounts. That likely brings the exposure of the FDIC closer to $6 trillion. But that’s pretty inconsequential at this point: using any reasonable accounting method, the FDIC is already bankrupt and will require hundreds of billions of dollars in government bailouts just to keep the doors open.

So, given the dire shape of its finances, what measures is the FDIC taking, you know, to batten down the hatches and all that?

For starters, they are expanding their mandate by guaranteeing bank loans – $350 billion and counting at this point. And the government has tapped the FDIC to play a pivotal role in guaranteeing the loans issued to buy toxic waste through the government’s highly problematic and fraud-prone new Private Public Investment Partnership (PPIP). The FDIC’s commitment to the PPIP is and may become limited based on its resources.

It is hard to draw any other conclusion but that hundreds of billions in new funding will be required to keep the FDIC operating. Given the catastrophic consequences of the FDIC failing, starting with a bank run of biblical proportions, there’s no question it will get whatever funding it needs. By loading the new loan guarantee responsibilities and the PPIP onto the FDIC’s back, the administration will go back to Congress and ask for the next large bailout.

Of course, in the end, all of this falls on the taxpayer, either directly in the form of more taxes or indirectly via the destruction of the dollar’s purchasing power. Another bale of straw on the camel’s back, and another reason to be concerned about holding paper dollars for the long term.

PS: If you still trust the government to take care of you and yours when the feces hits the fan, you’re on the path to financial disaster. But even in times of crisis, there are things you can do to protect yourself – for example, by betting against the insane machinations of the government and Fed. You can’t make them stop, but at least you can profit from them. Read about Bud Conrad’s favorite investment of 2009… by clicking here.

Weak Treasury Sales...Bond Vigilantes Rolling Into Town?

Anyone want to puchase debt at an artificially low interest rate from a party that's highly unlikely to be able to pay you back? Anyone?

Surprisingly...you're not alone! The Treasury auctioned off another $39 billion last Wednesday (it's crazy that we get immune to seeing these huge numbers) in an auction that "drew poor demand."

It really looks like the government will have to monetize a lot of debt (as previously laid out in an excellent guest article we ran a few months ago - link below).

Heavy monetization usually leads to inflation. Problem is, the inflation/hyperinflation call appears to be the most obvious one on the planet right now. And the obvious call is often not what plays out in the world of investing.

So can the Fed inflate its way out of this? Or is Robert Prechter correct that you can't beat deflation in a credit based system?

Further reading on this topic:

• Why the government will have to monetize the federal deficit
• What to do if deflation, the contrary play, wins out!