Fed Rate Hikes: A Roadmap to Financial Ruin

Dr. Marc Faber previews what might happen in the immediate future to the US Economy: Fed Rate Hikes, then cuts, then hyperinflation, and finally deflation.

FOR AS LONG as the Fed perceives the economy to be healthy, it is almost a certainty that it will continue to increase the Fed fund rate in baby steps to between 4.25% and 4.50%, and possibly even higher. Some observers believe that in order to gain credibility, Mr. Bernanke will increase rates more aggressively than Mr. Greenspan intended.

However, the economy is most likely far less healthy than what Fed officials believe. Plunging consumer confidence and especially the Consumer Optimism Index’s expectations seem to confirm this point (see the chart below). (The Consumer Optimism Index, compiled by Ed Yardeni, is the average of the Consumer Sentiment and Consumer Confidence indexes.) Note the close correlation between the Consumer Optimism Index and stock prices in the past, which would under normal circumstances suggest a significant downside risk for equities in the near term.

Fed Rate Hikes: Expansionary Monetary Policy

But here is my point: the market participants may be beginning to anticipate that the Fed will shortly (in the next three to six months) wake up to the fact that the economy isn’t as healthy as it thought. And once the Fed notices, home prices will decline (as is indicated by the sharp drop in the shares of homebuilding companies), and consumer spending will stall or even decline moderately. Mr. Bernanke, whose principal concern is deflation, will immediately cut interest rates again and move to an expansionary monetary policy.

Depending on the Fed’s view on the impending threat of asset deflation and its negative consequences for the economy, the money-printing press could, in this phase two of our roadmap to the next severe recession, possibly run at full speed. This renewed monetary easing is likely to stabilize asset prices. This is what the stock market may now already be discounting by not selling off and following the Consumer Optimism Index on the downside. However, in phase two of our roadmap to ruin, two new trends will likely become more persistent.

From the chart below, courtesy of Barry Bannister of Legg Mason, we can see that, in the past, upturns in commodity prices have always led to upturns in the Consumer Price Index, while downturns in commodity prices have always led to declining consumer prices – except for the period post-Second World War when, after 1980, declining commodity prices only led to a deceleration of consumer price increases (disinflation, as opposed to deflation). Why was the pattern of declining commodity prices bringing down consumer prices broken after 1980? Very rapid money supply growth and unprecedented budget deficits in peacetime led to rapid debt growth, which prevented consumer prices from deflating.


From yet another chart below, we can see that following Paul Volker’s monetary squeeze of 1979/ 1980, money supply growth exploded in the period 1982-1986. I would argue that if money supply hadn’t exploded at the time, it is likely that we might have experienced for the first time since the Second World War declining consumer prices for several years in a row. (This would certainly have been the case under a gold standard.) Note that whereas in 1983 most economists, including Milton Friedman, expected consumer price inflation to reaccelerate – based on the rapidly expanding money supply – it didn’t happen, as inflation had moved away from consumer price increases to asset inflation (bonds, stocks, and real estate).  

There were at the time two main reasons for the moderation in consumer price inflation. First, as can be seen from the second chart, commodity prices tumbled after 1980, which certainly removed some inflationary pressures for consumer goods prices. In addition, as a result of rapidly growing US consumption, Asian manufactured goods began to flood the US market and pressured at least manufactured goods prices.

This trend has continued, as Chinese imports began to increase very rapidly in the 1990s. Rising imports of low-cost Chinese goods then led to import price deflation and contained wage increases in the developed world. The trend to declining wages in real terms gained momentum in the last few years as more and more high-value services became tradable and allowed their outsourcing to countries such as India.

We can therefore say that, in the 1980s and 1990s, the developed world enjoyed the tailwind of declining commodity prices and the outsourcing of production and services to low-cost countries, which, despite easy monetary policies, didn’t lead to rising consumer price inflation. (Other factors contributing to disinflation were the peace dividend, privatizations, and aggressive cost-cutting measures by the corporate sector and – not to be forgotten – declining interest rates, which reduced the financing costs of companies.)

Fed Rate Hikes: Demand will Exceed Supply

But the next time the Fed embarks on a massive liquidity creating exercise (such as the one Mr. Greenspan implemented following the Nasdaq collapse in 2000), these favorable conditions may no longer be in place. For one thing, it is evident that the commodity cycle has turned up (see Figure 6). And while I don’t rule out a meaningful correction for industrial commodity prices, it would seem to me that the dynamics of demand and supply as a result of the growing need for commodities from countries such as India and China, which are in the process of industrializing at breakneck speed, are so vast that, in the absence of a global deflationary depression, the demand will structurally exceed supplies – especially for energy – for years to come.

Therefore, my view would be that we are at the beginning of a long-term upward wave in commodity prices that could last for another 15 to 20 years. (Commodity cycles, also called Kondratieff cycles – see the second chart– tend to last between 45 and 60 years from peak to peak.) Also, one should consider that whereas industrial commodity prices look stretched and vulnerable at present, many soft commodities such as cotton and agricultural commodities have not yet participated in the commodity cycle upturn. Their future rise could cushion – at least to some extent – any medium-term decline in industrial commodity prices.

So, whereas declining commodity prices provided expansionary monetary policies with a tailwind between 1980 and 2000, from here on their price increase could become a strong headwind. (In September the CPI increased by 4.7%.) As far as the benefits from low-cost imports and the outsourcing of services are concerned, it is debatable whether import prices will continue to deflate. I have no doubt that China and India are both at the beginning of huge market share gains in the production of goods and the provision of high-value services, which will keep some pressure on prices and wages in the Western world.

In fact, it wouldn’t surprise me if, one day, Chinese exports were to make up 25-30% of the world’s total exports, up from around 12% currently, and if research facilities in India were to account for a huge chunk of global R&D spending and any imaginable tradable services. But therein lies precisely the threat to higher global inflation rates, for two reasons. If both India and China are so successful at gaining global market share in export markets and in tradable services, their demand for natural resources – especially energy – could increase possibly far more than even the commodity bulls anticipate and pressure prices to far higher levels than we expect.

Moreover, if both China and India – not to mention a host of other countries such as Russia, other former Soviet Union states, and Vietnam – are so successful at hollowing out the economies of the Western world and especially the US, what will the governments of these “economically threatened” countries do? They will try to force these new competitors on the block to revalue their currencies in order to make them less competitive. Should this fail, however, or succeed only partially, the central bankers of the Western world will print money and debase their own currencies (competitive devaluation).


Fed Rate Hikes: The Temptation of Mr. Bernanke

This will be particularly tempting for Mr. Bernanke, who believes that budget and current account deficits don’t matter, as well as for US policymakers, since 90% of Americans don’t have a passport and so wouldn’t even notice that the dollar was losing value against foreign currencies.

Moreover, since the foreign indebtedness of the US is denominated in US dollars, at first sight the easy monetary policies by the Fed which are designed to lower the value of the dollar against its principal economic competitor and geopolitical arch-rival, China, which owns a big chunk of the American debt in the form of foreign exchange reserves, would seem to punish China most. (The Japanese would also be punished, but, feeling threatened by China, they would go along with any economic policy that could hurt China.)

As we have seen above in our roadmap to the next severe recession, the Fed will, in phase one, continue to increase short-term rates in baby steps. In phase two, when the Fed realizes that the economy is weaker than expected, it will reverse its tightening bias, cut rates, and ease massively. Along the way, it will blame the undervalued Chinese currency, which gives China an unfair competitive advantage for the soft patch in the US economy.

However, as I have tried to explain above, a policy where the Fed eases in the upward phase of the long-term commodity cycle, and with the US recording such large current account deficits and a staggering negative net asset balance that requires foreigners to acquire at least US$2 billion of US debts every day, could backfire very badly.

For one, it is far from certain that the coming soft patch in the economy – whenever it comes and however severe it turns out to be – will be accompanied by moderating upward pressures on consumer prices and wages. Commodity prices may possibly remain firm or ease only moderately, or some import price inflation may become visible. It is also conceivable that wages for employees in the service sector whose services are not tradable will rise more rapidly than in the past in order not to let wage increases fall behind the rate of consumer price inflation. (The vast majority of service jobs, such as those in the hospitality industry, retail, fast food, health and beauty care, government, and so on, are not tradable and, therefore, are immune from being outsourced to foreign countries.)

Moreover, since Mr. Bernanke’s main concern will be deflation of asset prices – in particular, homes – it is likely that the money-printing press will be turned on at full throttle. In any event, I suspect that once monetary policies reverse from a modest tightening bias, such as we have had over the past year or so, to an easing bias, the dollar and the bond market will begin to weaken in earnest. In fact, the weakening bond market may have already begun to discount this coming easing bias and its inflationary implications.

Fed Rate Hikes: Crisis of Confidence

In addition, I simply cannot believe that foreign creditors will forever accumulate US dollars when they realize that there is no will at all among US policy-makers to redress what are, in the long run, unsustainable external imbalances. Whether it is at that point of phase two of our roadmap to the next serious recession that the dollar will collapse against gold or foreign currencies is debatable,

but some crisis of confidence in the dollar is almost a certainty. The weakness of the dollar, even at a time of a soft economy, will likely lead to some upward pressure on US interest rates. This could force the Fed to ease more than it originally intended in order to support the asset markets.

At this stage, dollar weakness, rising commodity prices, and rising import prices could lift the rate of consumer price increases and the yield on long-term bonds above the rate of asset and wage inflation (declining asset prices and wages in real terms). If that were to occur, the economy wouldn’t benefit from the easier monetary policies at all. Moderate stagflation would follow. In this situation of poor or no economic growth but modest inflation, the Fed will likely opt for an all-out assault to revitalize growth with its monetary tools and massively monetize with “extraordinary measures”.

This would occur in phase three of our roadmap to ruin. Asset prices would then rise in dollar terms, but decline in terms of gold or – if there still existed any – hard currencies. In phase three, I wouldn’t rule out that the Dow Jones could rise to 36,000 (see James Glassman, Dow 36,000, New York, 1999) or 40,000 (see David Elias, Dow 40,000, New York, 1999), or 100,000 (see Charles W. Kadlec, Dow 100,000: Fact or Fiction, New York, 1999).

As an aside, I bought all three of these books to add to my “financial curiosities” collection. Note that they were all published in 1999. However, in gold terms, the Dow – no matter how high it will rise in dollar terms (even to 100 million) – will most likely decline to a Dow/ gold ratio of around 10. See the chart below, which shows how many ounces of gold are required to buy one Dow Jones Industrial.)


So, if the Dow were to rise to 36,000 as a result of massive money printing, the price of gold would rise to $3,600 in order to achieve a Dow/gold ratio of 10. I might add that at present the Dow/ gold ratio is still very high by historical standards and could, in an extreme crisis of confidence, decline to around 1, as was the case in the 1930s and in 1980 . With the Dow at 36,000, this would mean an ounce of gold would sell for $36,000 as well!

In this third phase of our roadmap to economic and financial ruin, consumer price inflation and interest rates will be extremely high (hyperinflation). The economy, however, will slump, as wage increases will badly lag behind the rate of asset and consumer price inflation. In phase three, wealth inequity will reach extremes and lead to a breakdown of American society’s social fabric. At the beginning of phase three, foreign exchange controls will be imposed and the ownership of gold will be declared illegal.

Also, oil and gold companies could at this point be appropriated and nationalized. (If not, we can be sure that an excess profit tax will be imposed.) In this phase all dollar bills below $100 in face value will have been retired and will be sought after as curiosities and collectors’ items. Phase three will be an age of “penniless billionaires”. There are currently more than 300 billionaires in the US, compared to fewer than 10 in 1980. The likelihood of a major war breaking out will be highest during this phase. Religious and racial intolerance will become dangerous, as the government will need to blame a minority for the “Schlamassel” (mess) it has created.

Now, I know that some readers will be questioning my sanity. However, what I am describing is already well under way. I am grateful to Barron’s for having published recently a figure that shows the loss of purchasing power of the US dollar in the last 100 years (see the chart below). The figure is actually the reciprocal pattern displayed by the price of gold. As the price of gold rises, the value of the dollar declines.


Barron’s explains that the log scale in the chart “of the purchasing power of the dollar begins with an index value of 100 at the passage of the Mint Act of 1792. The solid lines present periods when the dollar was convertible into a quantity of gold, and the fluctuations represent changes in the purchasing power of gold.” Note that the purchasing power of gold increased in the deflationary periods, or commodity downward waves, of 1814-1845, 1864-1895, and 1921-1942 – a subject Fred Sheehan discussed in a report entitled “Gold and ‘Flations.”

Barron’s continues: [T]he dotted lines present periods when the dollar was not pegged to gold, during and after the War of 1812, the Civil War, World War I and World War II. There was limited convertibility from 1945 to 1971, but the dollar lost purchasing power during the period. The link between the U.S. currency and gold was cut in 1971 and the loss of purchasing power accelerated. By 2004, the dollar had lost more than 92% of its original purchasing power. (Emphasis added)

What is interesting about the dollar’s long-term chart is that for as long as there was no Federal Reserve, the dollar maintained its purchasing power (1800-1913). But once the Federal Reserve Board came into existence, and especially after the link between the US dollar and gold was cut in 1971, the dollar’s value began to slide in earnest. My point is simply this: the last time around it took 100 years for the dollar to lose 92% of its purchasing power. But with Mr. Bernanke at the Fed, it won’t take another 100 years for the same to happen again! From here on, events will unfold at a rapid pace. This is a high-confidence prediction.

As a commentator recently remarked, Mr. Bernanke was moved from the Board of Governors at the Fed to become the Chairman of the White House Council of Economic Advisors four months ago, “bringing him inside the White House for a while so that the President could become comfortable with him before his appointment as the Chairman of the Federal Reserve Board was made”. Correct. The President had to be absolutely sure that Mr. Bernanke was really serious about the Fed’s power to print money and, in emergencies, to drop dollar bills from a helicopter in order to finance this administration’s ill-fated military follies and alarmingly rising debts which are fuelling asset inflation and financing excessive US consumption. So much for the Fed’s independence!

Fed Rate Hikes: Nero’s Devaluation of the Denarius

Following Nero’s first devaluation of the denarius in AD 54, when he reduced the coin’s silver content from 100% to 94%, it took almost 200 years for the denarius to lose around 70% of its value. In AD 244, under Gordian, the denarius still had a silver content of 28%. (Without machines that can print paper money, there are some physical limitations on how fast new coins with a lower and lower silver content can be issued and distributed throughout an empire.

With electronic money, this constraint doesn’t exist.) However, during the following 24 years the rate of depreciation of the denarius accelerated, and by AD 268, under Claudius Gothicus, the denarius had a silver content of just 0.02% (a 99.9% loss of value in 24 years)! I might add that the deflationists will tell you that the purchasing power of money will increase.

But if you look at the dollar’s long-term chart, how likely is this? In my opinion, at least in this instance, the trend of the dollar’s and other paper money’s diminishing purchasing power will, for now, remain by far your best friend. At the end of phase three, the system will break down. A major financial reform will become unavoidable. A gold standard will be reintroduced.

A deflationary stabilisation crisis will follow in phase four of our road to financial fiasco. Large segments of the population will be totally impoverished. Smart hedge fund managers will all have sold their businesses to banks and will have left the US to live in the Caribbean, Brazil, Singapore, or Thailand, while members of the Federal Reserve Board will either be in jail or defending themselves from class action suits in costly litigations in courts of law.

In the meantime, as John Law once fled France to settle in England in a luxurious home (which was later burned down), Ben Bernanke will flee the US in a hurry; unlike Mr. Law, however, he won’t even be able to afford to buy a shed with his billions of worthless dollars.

Marc Faber
November 23, 2005