Can Bernanke Contain Inflation?

Ben Bernanke has stated publicly that he can contain inflation in 15 minutes by raising interest rates. He thinks he can go the route of Volcker, but I have serious doubts over whether Bernanke can get away with raising interest rates under the present circumstances.

The number one constraint on Bernanke’s ability to contain inflation is the U.S. government bond market. I consistently say that what you should fear is not a stock market collapse, but a bond market collapse. For example, the 1987 stock market crash was the largest in history, yet it did not augur Armageddon; in fact, it was a mere hiccup on the way to record highs in the Dow. Stock market crashes do not result in the wholesale destruction of capital formation like bond market collapses do. It is the collapse of sovereign debts that has European nations scrambling to prevent an economic collapse.

I never look at anything in isolation. When government bond yields spiked in reaction to Volcker’s raising of interest rates, you saw no collapse in the U.S. economy. The national debt was under $1 trillion and Baby Boomers were in their 20′s and 30′s. The Fed under Volcker had the luxury of crushing bonds because the largest demographic was about to enter its most productive years. The demographic of those entering their retirement years was relatively small, which in turn meant immediate unfunded liabilities were relatively small.

Civilian Labor Force Ages 45-64

Now let’s take a look at the current situation. The national debt is over $14 trillion (excluding agency debt). Baby Boomers are retiring.  States are going bankrupt and public employees are about  to discover their pension expectations were too optimistic. Pension funds are loaded with toxic debt and are only solvent to the extent that their discount rate assumptions are  aggressive. Furthermore, let pension funds mark their securities to market and see what happens. There is a government bond bubble that is just waiting to pop. Those who believe Helicopter Ben has control over the bond market are truly living in a dream world. From the chart below, you can see for yourselves how the bond market has reacted to QE2.

What Volcker’s policies undoubtedly did was increase the growth rate of the national debt. This should come as no surprise. But Volcker had a margin of error to work with that we don’t have  today. In the charts below, note that the growth rate of the national debt has spiked even in a low interest rate environment. This suggests that this whole experiment with debt is coming to an end. When Bernanke raises interest rates to combat inflation, you will see a ton of collateral damage.

Given the tremendous rise in the national debt, demographic trends, and the growth rate of debt, I am positive that the only way out for the government is inflation. Bernanke’s statements concerning inflation make for nice sound bites, but raising interest rates is not a  practical solution here. Since the percent of foreign holders of our debt has increased since the 1980′s, an increase in bond yields created by the Fed will likely precipitate further selling in bonds, which will obviously create debt servicing problems.

I’ve been patiently waiting for the opportune time to go short U.S. government bonds. Well it appears that time has arrived.

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  • Nikeboy2008

    I’m new to your site…you have some very interesting posts..I’m trying to understand the relationship between the diff. bonds like USB, TLT, TNX etc…like today TNX was down but TLT and USB went up…where can I read up on this stuff? what’s the best way to short US bonds? to get maximum yield?

    • http://www.expectedreturnsblog.com Moses

      Hey Nikeboy2008,

      Well some of the ticker symbols you posted are indexes and some are ETFs. Also, some of those tickers measure yields and some do the opposite and measure the price of the bonds. So that explains why TNX went down (yield) and TLT and USB rose (bond price).

      For charting purposes, I would go with USB. For trading purposes, it is realistic for most investors to only trade ETFs. There are many ways to profit from higher interest rates, including locking in debt at current rates and repaying your debt in depreciated dollars. It all depends on your circumstances. TBT is also another option.

      • Nikeboy2008

        thank you Moses…one more question: With 2011 being a record year for mortgage resets, wouldn’t we expect a massive withdrawal of liquidity from the markets and expect bond yields to drop a huge amount? If yields drop, wont bond prices go up?

        • http://www.expectedreturnsblog.com Moses

          Well I would only expect bond yields to fall if the withdrawn liquidity floods to bonds. I don’t see that happening this time around.

          • Nikeboy2008

            where do you you think all this liquidity will go to? gold and silver?

          • http://www.expectedreturnsblog.com Moses

            Ultimately, yes.

  • Anonymous

    MK: I agree with your post with one caveat. Time to re-examine the classic “domino theory”. In these times, a failure in one key sector will not end the systemic risk. The FED is juggling too many greased balls with arthritic hands. Bernanke is 100% sure he won’t drop even one. The arrogance of the elitists knows no bounds. But even the puppet in the WH has faced a reality check. As for Bernanke and his co-conspirators. they will consider themselves masters of the universe until the inevitable implosion. It will be interesting to see how long they can maintain their version of an alternative universe. Next year could be very interesting for careful observers. Not necessarily bunker time, but it’s getting dangerously close.

    • http://www.expectedreturnsblog.com Moses

      I totally agree with the “domino theory” or “contagion effect”. A version of the domino theory is already playing out in Europe. Reality is going to set in sooner rather than later.

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