Why “Trumpflation” Might Not Happen

Oh, we needed a laugh to end the week.

From the Financial Times: “Janet Yellen has stressed the importance of central bank independence in her first public remarks after Donald Trump’s election victory… Ms. Yellen said it was ‘critically important’ that central banks had the freedom to make judgments about how best to pursue their goals. Her remarks followed attacks during the election campaign by Mr. Trump, who claimed the Fed had kept interest rates low to help the Obama administration.”

Heh… Anytime this topic comes up, we recall words attributed to the hapless Arthur Burns, who ran the Fed during the Nixon administration and set the stage for the near-hyperinflation of the late 1970s.

The story goes that he was asked by a German reporter why he pursued such a reckless policy. His reply? A Fed chairman has to do what the president wants or else “the central bank would lose its independence.”

But as long as the topic of Trump and the Fed has come up, it’s worth a few reflections going into the weekend…

“Right now the world economy is on a knife edge,” says Jim Rickards.

“Extreme inflation and deflation scenarios are equally probable depending on how Trump’s economic policies are implemented, and on the Fed’s policy reaction to those policies.”

Outlets have spilled a fair amount of digital ink in recent days on “Trumpflation” — the president-elect’s colossal public-works spending proposal that would put Uncle Sam ever deeper in hock, with the Fed simply printing “helicopter money” to cover the new debt.

“The Trump team,” Jim explains, “claims this spending can be financed with higher growth from his proposed tax cuts and his plans to reduce regulation.”

So we’re back to “supply side” economics and the “Laffer curve” — which tells us the deficit won’t blow out as long as long as economic growth is strong enough to generate more tax revenue.

But that didn’t work out so well the last time it was tried, during the presidency of Bush the Younger. Remember the 2001 and 2003 tax cuts? They were supposed to generate so much growth and tax receipts that we wouldn’t have to worry about the cost of the Iraq War or the Medicare prescription-drug program.

Instead, Bush doubled the national debt to $10 trillion and consumer prices roared higher — before they crashed during the Panic of 2008.

“Even if we get higher growth under the Trump plan, much higher deficits are inevitable,” Jim says. “This comes at a time when higher deficits are in the cards anyway because of baby boom retirement claims for Social Security and Medicare. If the Fed accommodates higher deficits with easy money and negative interest rates — so-called ‘helicopter money’ — then inflation is a near certainty.”

But then there’s the deflationary side of that knife edge.

We caution that Trumpflation is no sure thing. The Fed might assert a bit of independence after all.

“The deflation scenario,” says Jim, “is based on the Fed leaning against higher deficits with higher interest rates and positive real rates. When interest rates are above the rate of inflation, real interest rates are positive.

“It is also the case that higher government spending in the eighth year of a recovery with an initial 100% debt-to-GDP ratio will not produce much real growth. If the Fed reacts to deficits with high real rates, the U.S. economy could tip into a recession. There are already strong deflationary forces in the world arising from debt deleveraging, a dollar shortage, technology and demographics.

“Also, a strong dollar resulting from higher rates will increase the foreign exchange value of the dollar, import deflation and make dollar-denominated debt owed by emerging markets unpayable. This could lead directly to an emerging-market debt default crisis worse than the 1980s crisis in Latin America.”

On the side of the deflationary argument are these facts:

This morning, the dollar sits at another 13-year high… and yesterday, Ms. Yellen reiterated plans for an interest rate increase “relatively soon” — which nearly everyone interprets as “next month.”

But again, it could go either way. What to do?

“Investors should use the ‘barbell’ strategy,” says Jim. “This consists of inflation protection (gold, silver, natural resources, land and fine art) and deflation protection (10-year U.S. Treasury notes). The inflation and deflation portfolios are two ends of the barbell.

“In between, investors should hold about 30% cash, which reduces overall portfolio volatility and gives the holder optionality to pivot one way or the other when visibility improves. The complete barbell would have 35% inflation protection, 35% deflation protection and 30% cash.”

Jim cautions this isn’t a set-it-and-forget-it approach. “It requires continual monitoring and updating based on market developments. As visibility improves, the time will come to tilt toward inflation or deflation protection, but for now, the balanced approach is best.”

The major U.S. stock indexes are treading water as the week winds down.

The Dow is off about 30 points, back below 18,900. But small caps are powering ahead, the Russell 2000 up a quarter percent.

Amid the aforementioned dollar strength, gold is sinking ever closer to $1,200 — $1,208 at last check. Crude is edging back toward $45.

The only economic number of note is the leading economic indicators from the Conference Board. This composite of 10 supposedly future-foretelling numbers rose 0.1% in October.

In isolation, the number doesn’t mean much, but on a four-year chart, it’s apparent we’re on the downslope of the post-2008 expansion…

Regards,

Dave Gonigam
for The 5 Min. Forecast