If you watch the markets as closely as I do, you can see that the United States is on course for a serious economic adjustment. From our unsustainable annual deficits, to our massive debt load, to our out-of-control spending, it’s clear our financial situation is untenable.
And that’s exactly why Fitch warned last week it would downgrade the U.S.’s triple-A credit rating if the fiscal cliff isn’t resolved by the end of the year.
But while an adjustment is necessary, its timing could make all the difference in the world. If it happens at the right time, the resulting inflation could clear out the malinvestment, debt and excesses in the U.S. economy, and pave the way for a lasting recovery.
So Why Hasn’t That Happened Yet?
Well, the Federal Reserve’s money-printing and accommodative policies have certainly swelled the monetary base. But that money is simply not making it into the real economy, mainly due to ultra-low interest rates.
The money is going to the banks, and the banks are either holding it themselves or keeping it at the central bank. In fact, just look at the increase in commercial bank reserves held at the Federal Reserve over the past three years.
And while all this money sits at the Fed or on the banks’ balance sheets, it doesn’t move through the economy. In other words, the velocity of money is extremely low. There are a couple reasons for this inertia …
For one, banks are still hesitant to lend. But in addition, consumers and businesses are hesitant to borrow to fund purchases, create jobs or initiate new projects.
This reminds me of what Japan was facing at the beginning of its lost decade. In the late 1990s, the Bank of Japan also instituted a zero-interest rate policy, and investors all over the world expected the yen to depreciate and inflation to skyrocket.
But that didn’t happen because the Japanese economy didn’t generate enough activity. The yen remained relatively strong, interest rates on Japanese bonds stayed low, and the country faced persistent deflation.
Now I’m not saying the United States will go down the same road. The Federal Reserve says it has learned from Japan’s mistakes. That’s why, unlike the Bank of Japan, the Fed has directed its efforts at shoring up the banking system.
By supporting the largest U.S. banks, the Fed has given them the upper hand in generating loan growth. And as you can see in the chart below, the trend in commercial and industrial loans is up, although they’ve yet to regain their pre-crisis levels.
This may be a sign that the Federal Reserve’s policies are slowly beginning to generate economic activity. There’s no way to know now. But if this trend continues, 2013 may bring a top in Treasury prices, renewed dollar depreciation, and even significant inflation.
Have a Safe and Happy New Year!