The Fed Will Print Again

05/02/2011 2:44 pm EST

Focus: MARKETS

John Mauldin

Chairman, Mauldin Economics

With interest rates already near nil, the next slowdown could prompt more bond purchases and faster inflation, writes John Mauldin in Thoughts from the Frontline.

Albert Einstein is famously quoted as saying, “Compound interest is the eighth wonder of the world.”

I’m going to discuss compounding today—not of interest, but of inflation.

As you might expect, I am giving a great deal of thought as to how we get out of our current financial dilemma of too much debt and deficits that are far too high. While I will use US data for our illustration, the principles are the same for any country.

Let’s start with a few graphs from the St. Louis Federal Reserve Bank database (a true treasure trove of numbers). First, let’s look at nominal GDP over the last 11 years, from the beginning of 2000.

The data only goes through the third quarter of last year, so sometime this year it is quite likely that GDP will top $15 trillion.

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So, the economy has grown by roughly 50%, right? Give or take, that’s close to 4% growth. And in dollar terms, that is correct.

But what if we took out all the growth due to inflation? The economy would only have grown to $12.5 trillion.

And in fact, “real” (inflation-adjusted) GDP growth was just 1.9% on an annualized basis for the last decade, the lowest growth rate since the 1930s. What cost on average $1,000 in 2000 is now $1,250.

Now, to see this in an interesting graph, the Fed has real GDP based on 2005 dollars. You can see that we are about back to where we were in 2008, prior to the crisis, and growing well below trend. But if we adjust for inflation, growth has not been close to what it was in nominal terms.

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Now let’s run through a few “what-if” scenarios. What if the next 11 years look more or less like the last, with 4% nominal GDP growth? That would mean that in 2022, nominal GDP would be 50% larger than now, right at $22.5 trillion. But that is with only 2% inflation.

NEXT: What If Inflation Were Higher?

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What if inflation were 4%, with the same growth? Then nominal GDP would be $30 trillion!

What a roaring economy, except that gas would $8 a gallon (assuming current levels of supply and demand). In essence, you would need $2 to buy what $1 buys today.

Don’t even ask about health-care costs. If your pay/income did not double, you would be in much worse shape in terms of lifestyle. That is the insidious nature of inflation.

But let’s think about that from a federal budget perspective. Let’s assume we get 20% of GDP in federal tax revenues, which is roughly a little higher than the historical average. That means total tax revenues would be in the range of $6 trillion. With 2% inflation, revenues would be just $4.5 trillion.

If the federal government froze its spending at current levels for 12 years (no inflation adjustment), we would be running large surpluses under either scenario.

Higher inflation means US debt is easier to pay back, as nominal GDP is what we pay taxes on, not inflation-adjusted. Inflation is a tried and true method of dealing with too much debt. Inflation is also just another word for default, but it sounds so much better to the ear.

What if we don’t get robust growth? That means higher unemployment for longer periods. And what if we had a recession?

Let’s see how many in the audience think we can go another ten years without another recession...especially if we actually do start to cut spending in a manner that might get the deficits under control. I’m not seeing many hands.

But it would mean that the debt-to-GDP level might not look as bad—which might just be the plan, in some circles. But not one I want to be included in.

I was asked several times recently if we will see QE3, yet another round of bond purchases by the Federal Reserve . My answer is: not for some time; but if we had a recession, what would the Fed do?

They only have one lever now, as rates are already low. They are likely to print again. Which is inflationary. Which could give us rising inflation, with low growth.

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