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Enjoy the party, but beware of the hangover

Despite what was widely viewed as a weak employment report in early September, the U.S. economy appears to be on solid footing. Both ISM manufacturing and nonmanufacturing indexes for August were strong, with the nonmanufacturing index setting a record high. Initial unemployment claims have been in a steady and steep downtrend since 2010. Job openings in the private sector are higher than at any time since 2008, and employers complain they cannot find qualified candidates. So, while we aren’t quite in a boom, put any thoughts of recession on the back burner. But, make no mistake, inflation lies ahead.

Political gridlock

The No. 1 reason for this inflation forecast is the inability of governments at all levels, but especially the federal government, to rein in spending. At least once each year, we are treated to a confrontation between left and right over budgeting, spending and the deficit. But, nothing is ever resolved — the can is just kicked further down the road. The table above uses Congressional Budget Office baseline forecasts, which are quite optimistic. The table displays the baked-in growth in federal spending as a percentage of total economic output (gross domestic product).

09.22.2013 ART

Sources: Heritage Foundation; Jeffrey Gundlach/Doubleline Funds; U.S. Debt Clock website; Congressional Budget Office

2020 is only six years away, and 2030 but 16. From 1959-2008, the average revenue of the federal government as a percentage of GDP was 18.1 percent. For 2013, year to date, it is 16.9 percent. To balance the budget in the next six years, current tax rates must rise 43 percent. To balance it by 2030, those tax rates have to rise 59 percent. And these data points come from optimistic CBO forecasts. In an economy that the Fed considers so sluggish so as to not start its “taper” process, it is unlikely that taxes can be raised to these levels. Furthermore, the middle class, which pays most of the taxes, is rapidly shrinking due to the stealth inflation that has sapped their purchasing power. And, of course, the political chasm and resulting gridlock between the left and right has made addressing the automatic growth in federal spending essentially impossible.

The big story of the week was the fact that the Fed decided to keep the pedal to the metal (the “no taper” announcement) and the rapid growth in its balance sheet, which, essentially, is the creation of money that the banking system can lend several times over, continues unabated at $85 billion per month. Wall Street, the main receptor of the Fed’s largesse, sent the equity averages to all-time highs. But the Fed’s credibility took a hit, especially since the chairman telegraphed the “taper” way back in May. The very next day (Thursday), both jobless claims and existing home sales showed a much stronger underlying economy than expected. The markets now are questioning the Fed’s ability to even read the underlying trends.

Since the financial crisis, the Fed’s balance sheet has grown about $3 trillion, from about $800 billion to more than $3.6 trillion. During that same time period, U.S. Treasury debt outstanding has grown from $10 trillion to $17 trillion. In effect, the Fed has “monetized” 43 percent of the new debt over this period. Given the growth in automatic federal spending, it appears that monetizing the debt will be a major function of the Fed.

Conclusions:

• The economy is stronger than the Fed thinks and the unemployment report intimated.

• This is the first Fed in modern history to advocate higher rates of inflation (2.5 percent). Don’t be fooled; do you think that when the official CPI reaches 2.5 percent, it will automatically stop there because that is the Fed’s target?

• The rapid growth in automatic federal spending over the next few years will require the Fed to continue its large-scale asset purchases, just to support the Treasury’s need to issue debt and to keep interest rates down. Otherwise, the cost of interest alone will overwhelm the federal budget. The alternative, much higher taxation, is not politically viable.

• Ultimately, the dollar will weaken as the world recognizes that dollar debasement is occurring. Note that on the day of the Fed “no taper” announcement, gold rose by $55 an ounce. Market players aren’t stupid.

• Meanwhile, enjoy the continuation of the Wall Street party. But, beware of the inflation hangover.

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs.

Call them at 775-284-7778.

Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

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