STAGFLATION 2021

The two prominent economic theories known are Keynesian theory (after the Great
Economist, John Maynard Keynes) and Modern Monetary Theory (MMT). The new theory
adopted before the year 2000, so called MMT is the principle to solve economic problems
by printing more money irrespective of its long term negative effects on the economy. In
the last article, it was mentioned that the performance of each asset classes will be directly
linked to the money supply by the sovereign nations and so was it. Stock markets bounced
back with handsome returns before the economies could return to normal. It was purely
due to increase in money supply. In context to USA, Federal Reserve Bank (US Fed)
decides the interest rate and the money supply after keeping a watch on economic
conditions related to inflation/ deflation and fear of recession. Strong economic growth
usually leads to more hiring of people and higher wages for a set class of workers
depending upon the industry to industry, but not necessarily. Strong economic growth can
also lead to higher profits for corporates, which is a positive factor for the stock markets.
It is evident that the corporates and the financial lobbyists control the US Fed Reserve and
the government, because the decisions made are not to beat the inflation but to
accommodate profits for the corporates.

MMT advocates that the government should use fiscal policy to achieve full employment,
creating or printing money to fund government spending. The primary risk is once the
economy reaches full capacity then there is inflation, which can be addressed by raising
taxes and issuing bonds, to remove excess money from the system. It is a like a more
dynamic work for government without worrying about the excess money created over a
long period of time. Here government cannot default because it can print more money
whenever it is required. Once again MMT is for USA and not for the other nations on the
globe as US Dollar (USD) is dominant and reserve currency for the world. All debt on
USA is denominated in its local currency which is USD. As former US Federal Chairman
Alan Greenspan said (CNBC news channel), "The United States can pay any debt it has
because we can always print money to do that. So, there is zero probability of default."
Nations with debt denominated in their local currency can always print money to pay debt
and shall become the strategy of most. It gives birth to crony capitalism as and when major
banks would feel the pain shall be addressed in the policy by the Reserve Bank.

MMT advocates that the demand can be insensitive to interest rate changes, so a key
mainstream assumption is that lower interest rates lead to higher demand, is questionable.
It also advocates creating money alone does not cause inflation; spending it when the
economy is at or above full employment can. It is debatable by Keynesian theory
advocates. Currently, we are witnessing two sets of perception via MMT and Keynesian
Theory. Practically, MMT has been accepted and adopted since mid-nineties. Keynesian
theory is traditional policy or mainstream economics adopted by most of the nations in the
world. Taxing and issuing bonds to spend money is the mainstream economics where
unequal distribution of income is addressed. Maximum employment and stable prices are
the pillars of Keynesian theory. Here high interest rates are used to keep the inflation under
control and at the same time, gap between the rich and the poor is taken care of.
Four scenarios in Economy with combination of growth, de-growth, inflation and deflation:
1. Scenario 1 where Growth with deflation, which is good for economy and somewhat
better for stock markets in a way but citizens benefit the most as buying power increase
with steady wage. Every part of economy does not get the benefit.
2. Scenario 2 where Growth with inflation, which is most ideal condition for overall boom in
the economy where every part of economy gets the benefit.
3. Scenario 3 where De-Growth with inflation, which is also known as ‘Stagflation’. This
typical situation is like US economy during 1970s where the inflation is mushrooming to
hyperinflation and growth is shrinking to de-growth. It is not good for citizens but
benefitting a part of economy where government’s exchequer is getting cushion which is
already affected by de-growth.
4. Scenario 4 where De-Growth with deflation, which leads to collapse of every part of the
economy and to all the countries which are fully exposed to globalization. This is a very
bad situation like 1929-32 in USA.

In recent years, Federal Reserve has adopted the method of Quantitative Easing (QE) which
is buying own government bonds to increase money supply. The other method is
Quantitative Tightening (QT) which is vice versa of QE. Currently we are going through
Scenario 3 as mentioned above. In the last few months, we have witnessed the GDP growth
being volatile due to corona virus pandemic. Change of interest rates is an impact on the
psychology of borrowers so is on the activity of banks. It is an important role of Reserve
Bank of responsible countries to keep interest rates maintained above at a level where
inflation of respective country is ruling at. Currently interest rate at near zero is bad for the
long term prospects of the economy.

In March 2020, USA came out with huge money supply plan in the form of various
programs, the sum could be anywhere near to USD 7.5 trillion or 35% of GDP, with near
zero interest rates. The Emerging Countries are facing the crisis of their own to find the
way how to manage debt either by borrowing in local currency or USD, and USA would
be bailing out the world by providing loan in USD. There is huge money printing program
going on all over the world with extremely low velocity of money. Velocity of money is
very important for the growth. As huge money printing will have its own effects of
hyperinflation but it shall be the next chapter after stagflation, may be in 2022. As soon as
things would stabilize then the velocity of money shall increase and the already giant
money printed (money printing is digital) shall come under circulation, hence it would lead
to hyperinflation. Rise of socialism within capitalism is high on the cards and at the same
time deglobalization shall gain moment.

There is a debt of USD 28 trillion on USA with increasing trade deficit of USD 1 trillion
and zero interest rates. The annual inflation rate at 4.2% for the month of April’21 is the
highest level since 2008. It is beyond the expectations of the economists due to overheating
of the economy summing up with increase in money supply and commodity prices shooting
up. The yield on the benchmark 10 year US Treasury bond reached to 1.68% (as on 12th
May’21). It is also notable that the inflation jumped from 2.6% in the month of March to
4.2% in April, which is a huge jump. It shows that velocity of money is increasing gradually
and the increase in inflation is just a blip of money supply. We are in transition phase of
deflation to stagflation, then to hyperinflation. There is a negligible growth in volumes but
huge increase in price where examples can be taken from base metals to agricultural
commodities. A perfect example of stagflation.

It is becoming a compelling option for US Fed Reserve to increase interest rates and so
shall be forced to buy bond programs to keep bond yields low. Increasing interest rates
shall lead to collapse of equity and debt markets because the banks have adjusted
themselves to the statement of zero interest rate till the end of 2023 by US Fed Chairman.
The standard QE program of buying USD 120 billion per month will change, where US
Fed will increase the allocation to buy more bonds. It will be a Catch-22 situation for US
Fed. First of all, it believes that inflation is transitory and it shall be tamed eventually, so
interest rates shall remain at zero till the end of 2023. US Fed was expecting inflation to be
at 2% on long run average, so any action to increase interest rates in short term is not on
the cards until it becomes a compulsion if inflation rate persists at 4% or beyond for the
next few months. US Fed has to increase buying bond program even faster to prevent rising
yields on 10 year US Treasury. Once again to tame the yields, money supply will increase
so would increase the inflation. Therefore, US Fed is in a dilemma. It is a classic example
of stagflation and can also be phrased as ‘the dog catching its own tail’. This spiral will
end someday where increase in QE will not have any effect and pace of interest rates going
up will far exceed the expectations. As per the Keynesian theory, interest rates should have
been at more than 2% and money supply to be curtailed to deflate the overheating economy
but it cannot happen now. The reason being the giant money supply created in the last 20
years cannot be reversed in one go as it shall lead to the greatest depression ever, but
inevitable. Who shall take the blame? So, the money supply will increase to tame the yields
on US Treasury and interest rates shall go up gradually by the end of 3rd quarter of 2021.

While the US Fed provides huge injection of liquidity to the banks and the corporates
directly by buying the bonds from them and also investing in ETFs. Banks use this liquidity
to buy bonds to cash on arbitrage opportunity in interest rate differential or other structured
products of various kinds and shares, whereas in reality banks are diverting from the prime
business of lending money. Small percentage of this liquidity is going to economic
productivity. Corporations are buying back their own stocks by borrowing cheap money
and valuations of loss-making technology or ecommerce stocks are getting overvalued
because of easy money. In short, the money is rotating around in a vicious circle. It has
resulted into speculative bubble in the bond market and in the stock market. USA, Europe
and Japan are involved in the same type of activity also known as Modern Monetary Theory
“MMT”, increase money supply to solve money crunch. Such monetary theory was started
by Japan in 1980s soon after the bubble burst in the economy (1990-91), which proved to
be a failure since then. The US Fed’s balance sheet expansion by USD 7.47 trillion through
various stimulus package like CARES Act, bond buying program etc., is nothing but
increase in debt burden on nation. QE benefits debtors, since the interest rate has fallen
which means there is less money to be repaid. However, it directly harms creditors as they
earn less money from lower interest rates. Devaluation of a currency also directly harms
importers and consumers, as the cost of imported goods goes up. Such policy makes rich
people richer and poor people poorer. The wealth gap effect soon be seen in greater
magnitude and no wonder the recent loot after the killing of George Floyd is such effect
seen in USA. Social unrest can also be seen in South American countries, Hong Kong,
France and Spain to name a few. Socialism is a threat to Capitalism if the problem persists
for longer period of time, so it is important to have a short term pain to declare financial
emergency and to solve the debt problem at the earliest. Such drastic move will result into
Capitalism to have a short term jolt, which augurs well for the future.

Top 10 companies in USA reached nearly USD 10 trillion in market capitalization which
is more than half the size of US economy. The market capitalization of S&P 500 is
approximately USD 39 trillion and the size of US economy is approximately USD 19.50
trillion which means only S&P 500 index is 200% of US economy. The Buffett indicator
(which is market cap to the size of the economy) has hit a new high where the ratio reached
a historic high 200% and such warning hit before the actual crash comes in the stock
market. By any standards, it is at unprecedented heights and bubble shall burst anytime in
the near future. It shall be worst ever bear market in our life time. This time narrative is
“Don’t fight the FED”. It means do not sell shares and/or short sell the equity markets
because US Fed is buying corporate bonds directly and not only that it is printing money
but keeping zero interest rate steady upto 2023. Here the markets are liquidity driven and
not fundamental driven, so the markets are technical. US Fed policy of zero interest rate is
driving up the stocks as dividend yield of 0.50% on stocks is much higher than the figure
zero. In other words, any return above zero is having a greater yield, so it expands the PE
(Price earning ratio) of the stocks and ultimately driving up the stock prices. Sanity of
fundamental is lost and effect of easy money is seen. There are all indications of bubble in
the stock markets and the point from where it will burst, no one would know, but it is near.

The speech of Jerome Powell (Chairman of US Fed Reserve) at Jackson Hole (Mid-year
2020), it can be perceived that US Fed is tolerant to 2% inflation per annum and not only
that the inflation target of 2% was missed for the last few years, shall also be
accommodated in the future, which means it is tolerable to see inflation surpassing the
target of 2%. Imagine the situation of zero interest rate with 3 to 4% inflation rate where
negative real interest rate would be -3 to -4%. It is punishment to savers and reward to
borrowers. So, the interest rates should always be above the inflation rate. Gold and silver
are such precious metals where historically at the times when there is no confidence in the
financial system, they are the saviors of wealth. Once everybody starts realizing the
importance of precious metals to protect the wealth from depletion due to imminent rising
inflation, that will be the time when Gold and Silver skyrocket while we shall experience
collapse in the bond markets and the rising interest rates. The current scenario is just like
in 1976 to 1980, the period of stagflation. The probable end game of gold shall be similar
to 1980 when there was rising inflation and rising interest rates up to 18% per annum. Gold
peaked at USD 840 per ounce in January’80 from the base price of 95. Currently we are
passing through stagflation period with increasing money supply and gold is rising in
anticipation of inflation. The US Fed shall not interfere to curb inflation till the maximum
employment is reached which is usually at the fag end of growth in the economy. It shall
be too late to curb the inflation. The US Fed shall allow the inflation to rise and remain
visible for some time without interfering to curb in advance which means there shall be a
period of the inflation to mushroom into hyperinflation. It has given the all indications that
the platform is set for hyperinflation and it shall pick up with the increase in velocity of
money.

Problem still persists and it is not yet addressed that how the governments of developed
nations would reduce the huge debt, so the turmoil in future is obvious, hence the rally in
precious metals and commodities. Inflation is the only way out where inflating prices of
commodities in the economy shall increase the revenue for the nation to service debt and
reduce current account deficit in some cases. Inflation is such a type of indirect tax where
the citizens pay tax without realizing of having been paid the tax. It nibbles the money from
the savings and day today expenses of the citizens without having a name of taxation. It is
effect of wrong long term policies of the government.

There shall be domino effect of bubble burst in US Treasury Bonds, simultaneously

weakening USD then the money will flow into hard assets like Crude Oil, Gold, Silver,
Copper, and such other hard commodities. Gold already had led the rally in first phase and
other hard and agricultural commodities joined at later stage (2021), where COVID-19
effect has diminished. Gold and silver are such precious metals where historically at the
times when there is no confidence in the economy or systemic financial collapse, they are
the saviors of wealth. Once everybody starts realizing the importance of precious metals to
protect the wealth from depletion due to imminent rising inflation in the future, that will
be the time Gold and Silver will skyrocket while we shall experience the gigantic global
debt collapse may be in the months to come.

By Ankur Sharda

Published on 13/05/2021
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