Commodity and currency prices, reliable indicators of inflation, are signaling trouble ahead.

The road to a US insolvency crisis

Scott S. Powell, a visiting fellow at Stanford’s Hoover Institution, is a managing partner at RemingtonRand Corp. and Alpha Quest.

Today’s auction of 10- and 30-year US Treasury notes and bonds won’t tell us as much about the US economy as auctions used to – because the Federal Reserve has started buying up the notes as part of Fed Chairman Ben Bernanke’s “quantitative easing” effort.

Until recently, a plentitude of bidders for long-term US government debt was a sign the US economy was strong. But Bernanke is buying that debt in what he says is an effort to make the economy stronger.

This has a lot of people nervous – and the news that the Fed may spend up to $800 billion on this, rather than the $600 billion figure initially given, doesn’t help.

Bernanke: By buying up long-term gov’t debt, Fed chief courts chaos

Even if the purpose is to stimulate the economy, increase stock prices and lower interest rates, the effect of Bernanke’s policy may be monetizing the nation’s growing debt – printing new money to finance deficit spending.

The Federal Reserve’s balance sheet – the bonds and other instruments it has bought up – has already tripled over the last two years, to some $2.25 trillion, yet Bernanke seems unruffled. He also downplays the evidence that the Fed’s easy lending in 2003-04 (12 months in which the central bank loaned at just 1 percent to major financial institutions) helped inflate the housing bubble and thus create the 2008 meltdown.

Now, after holding that rate to nearly 0 percent for two years, Bernanke still shows no fear of inflation. Instead, he speaks of the threat of deflation.

Yet commodity and currency prices, reliable indicators of inflation, are signaling trouble ahead.

Oil prices are approaching $90 a barrel, while precious metals keep hitting new highs. A broad basket of commodities that includes copper, rubber, wheat, oats, pork, coffee, sugar and cotton – all of which are up over 50 percent in the last 12 months – is also sounding the inflation alarm.

How can it be otherwise? When manufacturers’ costs rise (as we’re already seeing in a host of indicators), inflation of consumer prices can’t be far behind. And how can prices not rise when the US imports more than it exports while Washington pushes the dollar lower against foreign currencies?

Inflation and devaluation must eventually drive interest rates higher – all bad news for the American consumer. But if Bernanke’s policy is widely seen as debt monetization and currency printing, the real danger is a US insolvency crisis that could destroy the dollar and bring global financial chaos.

Here’s how it could unfold

The Treasury now pays a blended cost of about 2.45 percent a year for some $9.14 trillion in publicly held US debt, the lowest rate in more than half a century. But inflation and devaluation will inevitably lead investors to demand a higher return.

The burden is manageable if the rate drifts back up to, say, 5 percent (double the current cost and close to the historic average). But a crisis in confidence would cause an immediate spike up in bond yields and interest rates.

We’re edging closer to the two conditions that could precipitate that crisis. One trigger would be the Fed balance sheet having grown too large for orderly liquidation except at fire-sale prices; the other would be disorderly (“failed”) US Treasury auctions, wherein bidders step away because they see the risks as outweighing the return.

Such a crisis would mean the cost of servicing federal debt would skyrocket – triggering a downward-spiraling liquidity crisis ending with the US government unable to finance its obligations.

And while Germany and the European Union were able to rescue Greece and Ireland (so far), there’s no one to bail out the United States.

What to do? In January, the new Congress must focus on even more than the tough nut of real deficit, debt and spending reductions. We need more Fed transparency – such as a public audit of its balance sheet, with stress tests to see the impact of sharply higher interest rates.

The news may be ugly – but hard facts are what’s needed to win public support for the sacrifices necessary to prevent the country from reaching a tipping point where mounting debt triggers an insolvency crisis.

Scott S. Powell, a visiting fellow at Stanford’s Hoover Institution, is a managing partner at RemingtonRand Corp. and Alpha Quest.

via the NYPost

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