Inflationary Deleveraging & the Illusion of Wealth

Excessively indebted societies must periodically deleverage bad debt to avoid an otherwise certain social and economic downfall. Central planners have two options when managing a highly indebted economy: allow painful bear markets and recessions to deleverage the system, which is deflationary (falling prices), or attempt to control a high inflation rate while keeping real interest rates negative over a long period, such that price increases in the economy outrun government debt, thereby lowering the debt/GDP ratio, which is inflationary (rising prices). Which option will the Fed pursue at this year’s Jackson Hole Symposium, what might the official narrative be, and what does that mean for the financial markets going forward?

The Fed doesn’t directly control the U.S. markets or economy because the dollars it supplies get deposited as bank reserves. In other words, the Fed can create new dollars, but it can’t force banks to lend them, or people and businesses to borrow and spend them. For this reason, the Fed has far less power over the economy and financial markets than most people understand. What the Fed does control is psychology and policy expectation, and by controlling the narrative, it can persuade market participants to do its bidding. The Fed’s narrative has been consistent since the 2008 Financial Crisis: rates will remain low, money-printing will back-stop the economy and markets to prevent the dreaded deflationary deleveraging, and inflation will be allowed to run higher, so borrow more money, take more risk, and buy more stocks! The Fed has staked itself in the inflationary deleveraging camp.¹

In the end, the Fed’s ability to effectively manage an inflationary deleveraging of our market system depends on market participants believing the narrative. To pull that off, it must occasionally convince Mr. Market the economy is strong enough to withstand the withdrawal of the Fed’s monetary heroin. Expect a heavy dose of that ‘idea’ to circulate the news today, but do not expect essential policies to change; remember, the goal is to deleverage the system through inflation.

While the Fed’s inflation policy results in persistently high asset prices, commonly referred to as “The Wealth Effect”, in reality it is “The Illusion of Wealth Effect”, which recently played out in Venezuela, as the cost of living outpaces asset appreciation and as the dollar becomes the final release valve for the dreaded, though unavoidable, deleveraging of our highly indebted society.² Every time the market doubts the Fed’s narrative deflation will take hold, so market crashes will occur as this scenario plays out. There will also be significant unintended consequences to innocent bystanders, most notably America’s middle class.

Think about it. Shaun

“The rich rules over the poor, and the borrower is slave of the lender.” ~Proverbs 22:7

1, 2 The Stansberry Digest, Daniela Cambone’s interview with George Gammon, August 25, 2021

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