The Federal Reserve Presidents make me laugh. Their stubborn belief that inflation is about to come roaring back is amusing. They are still clinging with confidence to their belief the Phillips curve, or the modern day equivalent – the Non-Accelerating Inflation Rate of Unemployment (NAIRU), can predict when inflation will perk its head back up.

Even though the last twenty-five years has barely shown a relationship between inflation and unemployment, the Federal Reserve is predicting inflation is just around the corner due to the supposedly tight labour market. I don’t know about you, but I see little evidence the actual relationship between unemployment and inflation:

looks anything like the theoretical relationship the Fed believes exists:

Yet the Federal Reserve insists on preparing the markets for higher rates. After all, according to their models, the economy is close to reaching NAIRU, and once it hits that level, inflation will explode higher.

Even though the simple act of preparing the markets for higher rates is causing a vicious collapse in inflation expectations, the Federal Reserve believes they know better than the market, and that any decline in inflation expectations is temporary.

The chart above is the 5 year break even inflation level, but all the different terms look similar. Over the past few months, the market has priced in collapsing levels of inflation.

Maybe the Federal Reserve will be right. Maybe inflation is about to take off. It’s not like the market has never been wrong.

But I don’t see it. As it has become clearer to the markets the Federal Reserve is about to embark on a rate hiking campaign, inflation expectations have plunged. After all, if you think about what is a bond market’s worst fear, it is inflation. As a Central Bank tightens, it should reduce the market’s fear about inflation, and thus bring down inflation expectations.

Especially when the economy faces the highest debt levels in recorded history. Increased debt loads make an economy more sensitive to rate hikes. It takes less and less of a rise in rates to slow down economic activity.

And herein lies the problem. The Federal Reserve is clueless to the fact they have already caused a global economic slowdown with their tapering of the QE programs and the threats of higher rates. Perhaps the Federal Reserve needs to flush out the system. I understand that argument. But that is not what the Federal Reserve believes. The FOMC members are convinced the US economy can handle higher rates. The problem with that theory is the market is already telling them that the economy can’t…

Credit spreads are blowing out. Financial conditions are tightening. Inflation expectations are collapsing. All of this and the Federal Reserve has not even tightened yet.

Ever since the 2008 credit crisis, all Central Banking mistakes have been tightening too soon. Most of these tightenings had to be quickly taken back when the economy proved to be more sensitive to rates.

The US economy is clearly showing signs of stress from the declining levels of liquidity. Why does the Federal Reserve not see this?

It’s like they somehow miraculously believe the olden days of expanding private sector credit growth will return. Yet each time they have attempted to take away liquidity, debt destruction has gained traction, and inflationary expectations have sunk.

Let’s go over the history of 5 year breakeven inflation levels since the 2008 credit crisis. Right off the start, the Federal Reserve had no clue how quickly the vicious cycle of debt destruction could take hold. They were late recognizing the severity of the crisis, and by the time they acted, 5 year breakeven levels were negative! Think about that for a second. The market was pricing in negative inflation levels for the next five years!

When the Federal Reserve finally woke up, they flooded the system with money in the form of QE, and inflation expectations returned to more normal levels.

Thinking they had saved the day, the Federal Reserve stopped expanding their balance sheet and waited for inflation to take off. Except it didn’t.

As soon as they stepped off the accelerator, the economy (and inflation expectations) sank. The true extent of the damage done during the 2008 credit crisis sank in. Realizing more was needed, Bernanke signalled more QE was on its way at the Jackson Hole Central Banking conference in 2010.

This did the trick for a while, but because the size of the balance sheet expansion was known in advance, inflation expectations peaked ahead of the end of the program, and fell in anticipation of the winding down of the program. With no QE, break even levels fell even further, and Bernanke tried a novel approach of term expansion of the Fed’s balance sheet with Operation “Twist.” That helped stabilize inflation expectations, but realizing creating inflation was harder than originally believed, Bernanke surprised the market with QE3.

That program was open ended and frightened the market to some extent. The highs in inflation expectations were made on the day of the announcement. While in operation, QE3 managed to keep break evens within the recent range. Yet since the end of QE3, break evens have headed only one way – down. First it was the taper that pressured levels lower. Then it was the Federal Reserve’s preparing the markets for the first rate hike.

And although 5 year inflation breakeven levels have not collapsed like 2008, the last six months has seen the level move from 2% down to 1.10%. We are now sitting at levels not seen since 2009.

Every Federal Reserve President speech that reaffirms a rate hike pushes that level down a little bit more.

You might be saying – who cares? It’s not like inflation is good. And to a large degree you would be correct. It would be great if our economy could handle 1.10% five year inflation break even levels. In fact, why not even have inflation even lower? What’s wrong with 0.50% or 1% inflation?

The problem is the enormous debt burden of forty years of irresponsible monetary policy has made a low inflation environment untenable. Low inflation makes the real_cost of debt higher. Therefore given the high debt load, the economy quickly slows down as the cost of debt increases. This causes even less inflation, which in turn increases the _real debt cost, which only slows down the economy all the more.

It is too late to think this debt will be repaid back in real dollars. The only way out is to inflate our way back to manageable debt levels. The longer the Federal Reserve pretends otherwise, the more often we will quickly sink back into a slump.

Japan thought they could escape a balance sheet trap by raising rates. It didn’t work for them, and it won’t work for the US. The only way out is for the Federal Reserve to be responsibly irresponsible.

To a large degree no one knows the true extent of the problem. That is why it is so important for the Federal Reserve to watch for signs they are too tight. These signs are everywhere, yet the Fed is blind to them. The longer they push down this road, the more likely for a big financial accident.

Thanks for reading,

Kevin Muir

the MacroTourist