Zero-Flation

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by Joshua Enomoto, Founder of ContangoDown.com and FutureMoneyTrends.com contributor

On a long enough timeline, the survival rate for everyone drops to zero.
Although this statement is nowadays associated with the popular alternative media website, Zero Hedge, the phrase actually is attributed to Chuck Palahniuk, author of the book Fight Club, for which the movie of the same name was inspired. The plot revolves around an unnamed narrator who subconsciously creates a Nietzschean Übermensch in the form of a charismatic archetype, Tyler Durden, to better cope with the frustrating disenfranchisement that the narrator is battling. In many ways, investors have felt disenfranchised from their government and their central bank policies, leading many of us to find solace in financial Tyler Durdens. We carry on in our normal lives, working side-by-side with our cubicled co-workers, but when the clock counts down, we immediately metamorphose into truth-seekers, quietly stacking gold, silver, guns, food and ammo.

But is the threat an external reality or are we simply pushing the upper boundaries of Schadenfreude, much like the addiction the narrator finds himself chained to? For the astute investor, the dangers of inflation, and the ensuing hyperinflation, has been the core battle-cry of the hard-asset movement. We have to understand that the basis of this threat is very much steeped into our collective psyche. Consider the words of famed economist, Milton Friedman:

Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.

There can be no doubt that the monetary base has dramatically increased since the financial crisis of 2008. Even the Federal Reserve acknowledges this.

With such a huge spike, no financial analyst or precious metals expert could be blamed for believing that this would lead to astronomical rates of inflation, perhaps even causing the U.S. dollar to lose its world reserve currency status. However, the reality is that gold and silver, while recently experiencing a mild rally, have been on an aggressive decline since October of 2012 and the CRB index, an oft-referenced indicator of inflationary pressures, shows no sign of rising prices as a result of excessive monetary circulation.

Proponents of the inflationary forecast insist that this monetary base has to go somewhere, with that somewhere being the American populace, resulting in the greatest bout of inflation in modern history. It is argued that banks will be incentivized to dump these excess reserves into the open market, especially given the dramatically higher yields that are currently being generated.

But the question many should be asking is, does the extra monetary base have to be circulated? Investors should absolutely be wary of phrases such as “have to:” it implies either coercion or inevitability, and while all of us in the financial editorial sector have been guilty of hyperbole from time to time, there are extraordinary variables involved with forecasting the effects of the Fed’s monetary policies.

In this case, an under-appreciated change in Fed policy is the payment of interest on reserves. From the statement released by the Board of Governors of the Federal Reserve System:

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    The Federal Reserve Board on Monday announced that it will begin to pay interest on depository institutions’ required and excess reserve balances. The payment of interest on excess reserve balances will give the Federal Reserve greater scope to use its lending programs to address conditions in credit markets while also maintaining the federal funds rate close to the target established by the Federal Open Market Committee.

Now why is this important? As John C. Williams, president and chief executive officer of the Federal Reserve Bank of San Francisco, in his Economic Letter to the Federal Reserve Board, writes:

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    The opportunity cost of holding reserves is now the difference between the federal funds rate and the interest rate on reserves. The Fed will likely raise the interest rate on reserves as it raises the target federal funds rate. Therefore, for banks, reserves at the Fed are close substitutes for Treasury bills in terms of return and safety. A Fed exchange of bank reserves that pay interest for a T-bill that carries a very similar interest rate has virtually no effect on the economy. Instead, what matters for the economy is the level of interest rates, which are affected by monetary policy.

Essentially, the payment of interest on reserves allows for a more orderly distribution of the monetary base rather than a mad rush of capital as the incentivization of reserve holdings involves yields. And while no one can guarantee that this policy change will prevent hyperinflation in the future, we can at least be assured that the powers-that-be are cognizant of this very potential.

Moving forward, savvy investors will need to address the threat of zero-flation, the idea that central bankers shockingly care more about inflation than the folks on Main Street, and have plans to mitigate it. Zero-flation is a far more pernicious enemy, as simply acquiring monetary hedges will no longer suffice: investors will need to be far more shrewd and require greater depths of research and analysis in order to successfully transition through this new economy.

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