Falling Dollar Means Rapid Consumer Price Inflation

By: Daniel Amerman | Thu, Oct 21, 2010
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Overview

Finally and with the greatest of reluctance - the US government has begun the defense of the US economy. This essential and long overdue defense is likely to be extremely painful for US investors, precisely because it is so long overdue. To return strength to a US economy mired in growthless depression requires an extraordinary action - the Federal Reserve and US government are openly going after the value of the US dollar.

For the minority of the US population who are aware of and following these developments, the "headline" attack on the US dollar is the Federal Reserve's imminent likely return to quantitative easing. The current discussion is that this will take the form of the Fed creating money out of thin air to fund US government budget deficits through the direct purchase of government bonds. No more pretenses, but openly getting down to the ugly business of outright monetization on a massive scale. This strategy aims to deliberately knock the dollar off its pedestal in the short term, and possibly ends the dollar's status as a global reserve currency in the longer term.

This focus on quantitative easing misses the immediate danger, however, and the reason for the assault on the dollar. For the US economy to grow again, US exports must become less expensive, while US imports must simultaneously become more expensive. Imports sharply rising in price means an immediate exogenous price shock that will send consumer prices rising for everything imported into the US. This immediate domestic consumer price inflation is the necessary consequence of a nation successfully slashing the value of its own currency relative to other currencies, as we will cover in this article. It is this second blade of a double assault on the value of the dollar that will be first hitting investors and consumers, even while the focus is on the first blade of quantitative easing.

(The word successfully is underlined above because it is an assumption, we don't yet know how the counterattacks will play out if and when currency devaluations grow competitive between nations.)

For the overwhelming majority of US savers and investors, this assault on our currency by our own central bank and government will be catastrophic. A glittering exception is, of course, gold which just reached $1,380 an ounce last week. Even for gold investors, however, this assault by the US government on its own currency carries hidden risks that could involve giving up all the real (inflation-adjusted) profits from possibly the best time to buy gold in our lifetimes.


The Dollar's Rapid Descent

The Federal Reserve has been openly assaulting the dollar by threatening outright monetization of US government deficits. Simply put, the US government would continue to spend "stimulus" and other dollars without limit, and the Federal Reserve would directly create the money as needed to purchase the Treasury bonds. The monetization amounts vary as the Fed threatens dollar buyers through the use of rumors, with a range from this week's widely reported $100 billion a month monetization rate, to $2 trillion over the next year, to whatever it takes to get what the Fed wants.

In some ways, not all that much has changed. We still have an effectively bankrupt nation which depends on running trade deficits to pay for the day to day standard of living for its citizens. The Federal Reserve has been monetizing on a massive scale for two years, it has just been doing it to manipulate the mortgage and other markets rather than directly funding the Treasury. A bankrupt government, that can't pay its current bills, has no chance whatsoever of paying for legally binding promises to 78 million Boomers approaching retirement age - except through inflation, as I have been writing books and articles about for years now.

What has changed is the intent and the method, however. The Federal Reserve is openly threatening the US dollar, and this is extraordinarily serious, because if there is one thing a central bank can do at will, it is to annihilate the value of its own symbolic currency. Also, as I wrote about extensively this past spring, the previous monetization was "sterilized", with the Fed creating barriers to keep the new dollars out of circulation, which sidestepped immediate inflationary effects, albeit at a price of partially hollowing out the real economic basis of the US banking system. The current proposal is the real deal, however, with the Federal Reserve directly creating dollars which the Treasury puts directly into the money supply.

The Fed's threats have caught the full attention of the global currency markets, as intended. The US dollar hit a 15 year low against the yen last week, and a 17 year low against the Chinese yuan. The US dollar has fallen for five weeks against the euro, and reached parity with the Australian and Canadian dollars. According to the Dollar Index used by International Exchange, Inc., the US dollar has fallen by 4.2% against a global basket of currencies over the last month (source: Bloomberg).


Rapid Inflation

We have to keep in mind that the goal of the federal government through openly threatening (and almost certainly carrying through with) monetization is not monetization for its own sake. No, the immediate goal is to resuscitate the economy. And for the economy to be resuscitated, that means that the United States must export more goods, while importing fewer goods. So more jobs are created in producing the products that are exported as US exports grow more competitive, and separately, jobs are also created as more products are produced domestically, because imports are no longer as cheap.

Those are the really key words - imports are no longer as cheap. Last year I wrote the article "Inflation Supply Shock Inferno" with an accompanying video (linked below) that used simple to follow illustrations to explain how this deliberately created price shock can quickly lead to explosive inflation in the US. Here's a key excerpt, with round number illustrations (the same principles work with a 10% change and a 20% change):


The Inflationary Supply Shock Inferno

What happens to prices? Let's look at Wal-Mart, Target and Best Buy. What all those "big box" stores have in common is that their aisles are stacked full of goods made in China, Japan and other nations - for which the United States can't really pay. Goods that we're only able buy because they're buying our treasury bonds in exchange, essentially propping up our trade deficit by paying for our budget deficit. Now, if the dollar drops in half, that means the cost of virtually everything that we buy in those stores would double overnight.

So, instead of paying $1,000 for an HDTV - we're suddenly paying $2,000.

Instead of paying $3 for a plastic spatula - we're suddenly paying six dollars.

Instead of $70 for a dish set - all of a sudden it's $140. We have an immediate, drastic inflationary price shock, with the prices for everything we bring in from overseas soaring overnight.

Most importantly, let's not forget about oil. The US consumes far more oil that it produces, the situation is getting worse, and 60% of US oil consumption had to be imported by August 2009. It's quite ironic, really. Day after day, the city streets and interstate highways of the United States fill up with the largest fleet of massive, gas-guzzling vehicles in the world. Yet, we produce neither the gasoline to run to them, nor the real goods and services to pay for that gasoline. Ironically, it is the other nations of the world, almost all of whom have smaller fleets per capita, and more fuel efficient vehicles on average, who subsidize the driving habits of the United States by deferring consumption, propping up the dollar, and effectively lending the money to the US through purchasing our government debt and other financial assets.

Let me suggest that this is an extraordinarily unstable situation. If there is anything that a long term history of the world shows us, it is that as comfortable and natural as unstable relationships can seem to be when we are in the middle of them, equilibrium will be sought by the very fundamentals of economics and human behavior, and the return to equilibrium may be sudden and catastrophic.

If we have to actually start paying our own way, and other countries stop manipulating the value of the United States dollar, then we can expect a sudden rise in the price of oil. Which in turn raises the cost of transportation, heat, energy - and almost everything else.

Instant price shock. Think about the mid 1970s, only permanent this time.

What about food? Even the food we produce domestically heavily relies upon fertilizers, which rely on petrochemicals. Oil price shock means food price shock.

Let's consider a common shopping trip, of the kind that tens of millions of Americans do every day.

Start at the gas station where more than half the oil is imported -inflationary price shock.

Move on to the Wal-Mart filled with imported goods that can't be paid for on a national basis - inflationary price shock.

Next to the Best Buy big box electronics store, also filled with imported goods that can't be paid for on a national basis - another inflationary price shock.

And finally to the grocery store, filled with drastically more expensive imported foods that rely on oil for transport, and domestic foods that rely on petrochemical-based fertilizers - still another inflationary price shock, for four external supply based inflationary price shocks in a row, on all four stops.

If you want to use the technical term for what I've just been describing, they are what is known as "exogenous supply shocks".

A series of interrelated exogenous supply shocks can set off a chain of events that will lead to an economic forest fire growing out of control. Each place the fire spreads to - sets off the places next to it. As the fires combine their strength, the flames grow hotter still, and spread to still more places, until there is an inferno. This inferno then creates the most dangerous part of inflation: inflationary expectations. Supply shocks can come and go, but once people incorporate inflation into their behavior, this sets off a chain of events that can go beyond the control of the government and the central bank. There was about a 7 year lag between when the inflationary exogenous supply shock of the oil embargo of 1973-74 hit an already inflationary American economy, and when inflation peaked in 1980-81. Inflation creates its own fuel once external supply shocks ignite the fire.

The complete article and video can be found at:

http://danielamerman.com/Video/Shock.htm


The Urgent Need To Attack The Dollar

To many people, the idea that the solution to an economy in deep trouble is for a nation to attack the value of its own currency may be difficult to understand, even counterintuitive. If you're already in bad trouble, why make things worse by attacking your own currency?

The answer can be found in elementary economics, something which the US government has been doing its best to ignore for more than 10 years now. If you have a "strong currency", that means that your currency is high in value relative to other currencies. Having a stronger currency makes it cheaper for you to buy goods from other nations, but more expensive for you to sell goods to these nations. Thus domestic jobs are lost and the real strength of your economy is reduced in two separate ways: your exporters have a powerful price disadvantage when trying to sell to other nations, and your domestic producers have trouble competing with the cheaper goods coming in from overseas.

In a normal economy with a responsible government that is looking after the interests of its own citizens, the situation of having a "strong" currency is more or less self correcting. The result of a strong currency is that you export less and import more, which means that you can no longer pay for your imports. Therefore the value of your currency corrects by dropping until a level of equilibrium is reached, and exports more or less balance with imports.

At least that is how it is supposed to work in a theoreticalworld where governments don't manipulate the value of their own currencies. In the real world, governments (of course) do manipulate the value of their currencies to try to gain competitive advantages for their own citizens. In the past, this often led to a counterattack from the nation whose economy was under assault. These are not new concepts, and historically, nations usually defend their economies when another nation effectively assaults their economy through currency manipulation.

However, this has been precisely the situation with the US economy for more than 10 years now, most openly with China. Rather than counterattacking - the US government in successive administrations adopted a policy of pre-emptive surrender. Under a naïve academic theory of so-called globalization, that in fact ignored the real world "elephant in the room" of massive Chinese currency manipulation, much of the US real economy was exported to China and other nations. Of course, the academics generally weren't the decision makers, as this situation worked to the short-term benefit of many major corporations and banks, with the side effect of a corresponding hollowing out of the US real economy.

As covered in my article on the subject "US Employment May Be Hammered By Euro Plunge", linked below, the situation was greatly exacerbated by the falling euro this past spring.

http://danielamerman.com/articles/Employ.htm

As explained in that article, the entirely predictable result of a falling euro - there is no surprise factor here - is that a severely wounded US economy could not recover so long as the dollar was strong relative to the rest of the world. US workers in the US economy were in desperate need of help, but instead US government policies kept the dollar high, which meant US companies were handcuffed in their ability to export goods, as well as handcuffed in their ability to fight against artificially cheap imports that were the result of Chinese and other currency manipulations.

Finally and belatedly, the US government is taking the only action that it can take to try to revive the US economy and pull it out of the growthless depression (in real terms) that it has fallen into. Currency manipulations from other nations can no longer be tolerated, and that means the US government must competitively knock down the value of the dollar relative to other currencies.


Boomers & Retirees Will Be The Victims

The increase in prices briefly illustrated above isn't theory, and it isn't paranoia - it's the objective. To resuscitate the US production of goods and the real economy, imported goods must become substantially more expensive in the United States than they are right now.

What this will lead to is a rapid redistribution of wealth within the United States.

Many US manufacturers will benefit. US workers will, while on average likely having a lower standard of living, still have an ability to adapt. Wages will at least partially rise with inflation. More American workers will be finding jobs.

But there will be victims, tens of millions of innocent victims, and they can be identified primarily by demographics and past behavior. The most numerous victims will older Americans, Boomers and retirees, who have responsibly worked their entire lives. People who don't have all that many working years ahead of them, and who have accumulated savings both in dollars, and in financial instruments that are subject to devastation from high rates of inflation.

It is these Americans whose future lifestyle will be sacrificed in order to try to bring jobs back to America. Again, this is no theory, but what is happening in real time. The US government and the Federal Reserve are openly coming after the value of all of our savings. There should be daily headlines running in every newspaper in the country about the destruction of the savings and lifestyles of older Americans - but there are not.

It is a deeply unfair world. However, there is one investment that has been doing remarkably well and has a good chance of continuing to do remarkably well, and that is that tangible, fundamentally contra-cyclical investment which is gold (as well as silver and some related commodities).

That gold should hit a record price of $1,380 an ounce even as the Federal Reserve openly discusses monetization in order to bring down the value of the dollar is no surprise. It is merely a minority of people rationally acting in their own self-interest. And as more and more of the population awakens to what is happening to the dreams they built over decades, and desperately try to hang onto at least part of what they've built, there would seem to be a very good chance that we've just seen the very beginning of the gold bull market.


Protecting Yourself

The simple solution is to pull all you can out of paper investments and symbolic currencies, put them in the gold, and hunker down to survive the still coming crisis.

Unfortunately, however, we live in a complex and deeply unfair world, that makes mincemeat of emotional reactions and simple solutions. As illustrated in step-by-step, easy to understand - but irrefutable - detail in the article "Hidden Gold Taxes: The Secret Weapon Of Bankrupt Governments" linked below, a simple solution of just buying gold leaves you handing a good chunk or perhaps most of your starting net worth over to the government by the time all is said and done. The way the government - under existing laws - effectively confiscates the wealth of gold investors in a highly inflationary environment is little understood by most gold investors, but should form the central point for their investment strategies.

http://danielamerman.com/articles/GoldTaxes1.htm

Let me suggest an alternative approach,which is to study, learn and reposition. Almost all financial and economic articles that you see today are really about the upcoming re-distribution of wealth, whether those words are used in the article or not. To have a chance, you must learn not just how wealth will redistribute, but how unfair government tax policies (that can be relied upon to increase in unfairness) will cripple most simple methods of attempting to survive inflation.

Then, yes - buying gold (and perhaps a lot of it) can be one key component of a portfolio approach, as discussed in my Gold Out-Of-The-Box DVD set. Use multiple components, each doing what they do best, shift the components in a dynamic strategy over time, and position yourself so that wealth will be redistributed to you in a manner that reverses the effects of government tax policy. So that instead of paying real taxes on illusionary income, you're paying illusory taxes on real income. And the higher the rate of inflation and the more outrageous the government actions - the more your after-inflation and after-tax net worth grows.

 


Do you know how to Turn Inflation Into Wealth? To position yourself so that inflation will redistribute real wealth to you, and the higher the rate of inflation - the more your after-inflation net worth grows? Do you know how to achieve these gains on a long-term and tax-advantaged basis? Do you know how to potentially triple your after-tax and after-inflation returns through Reversing The Inflation Tax? So that instead of paying real taxes on illusionary income, you are paying illusionary taxes on real increases in net worth? These are among the many topics covered in the free "Turning Inflation Into Wealth" Mini-Course. Starting simple, this course delivers a series of 10-15 minute readings, with each reading building on the knowledge and information contained in previous readings. More information is available at DanielAmerman.com or InflationIntoWealth.com.

 


 

Daniel Amerman

Author: Daniel Amerman

Daniel R. Amerman, CFA
The-Great-Retirement-Experiment.com

Dan Amerman

Daniel R. Amerman is a financial futurist, author, speaker, and consultant with over 20 years of financial industry experience. He is a Chartered Financial Analyst (CFA), and holds MBA and BSBA degrees in Finance from the University of Missouri. He has spent seven years developing a large, unique and intertwined body of work, that is devoted to using the foundation principles of economics and finance to try to understand the retirement of the Baby Boom from the perspective of the people who will be paying for it.

Since 1990, Mr. Amerman has provided specialized quantitative consulting services to financial institutions, with a particular emphasis on structured finance. Previously, Mr. Amerman was vice president of an institutional investment bank, with responsibilities including research, synthetic securities, and capital market originations.

Two of Mr. Amerman's previous books on finance were published by major business publishers. "COLLATERALIZED MORTGAGE OBLIGATIONS, Unlock The Secrets Of Mortgage Derivatives", was published by McGraw-Hill in 1995. Mr. Amerman is also the author of "MORTGAGE SECURITIES: The High-Yield Alternative To CDs, The Low-Risk Alternative To Stocks", which was published by Probus Publishing (now a McGraw-Hill subsidiary) in 1993. Advertised by the publisher as a professional "bestseller" for four quarters, an Asian edition was sold as well.

Mr. Amerman has spoken at numerous professional seminars and conferences nationwide, for a variety of sponsors including New York University, the Institute for International Research, and many others. After the publication of his prior books, he acted as keynote speaker at a number of banking related conferences over the next several years.

This article contains the ideas and opinions of the author. It is a conceptual exploration of general economic principles, and how people may - or may not - interact in the future. As with any discussion of the future, there cannot be any absolute certainty. What this article does not contain is specific investment, legal or any other form of professional advice. If specific advice is needed, it should be sought from an appropriate professional. Any liability, responsibility or warranty for the results of the application of principles contained in the website, pamphlets, videos, books and other products, either directly or indirectly, are expressly disclaimed by the author.

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