the fed and inflation ~ must read

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    The Fed & Inflation


    Many commentators have observed that the consequence of the activities of the Fed have been inflation and currency debasement. I personally can remember as a kid when my dad bought himself a pair of worsted wool long pants for around $3. Today that same pair of trousers would cost around $150.

    What the commentators seem to want to brush aside is the other side of the equation. At the time he bought those trousers, my old man was probably earning around $50 a month. Today, the same job he was doing then commands around $4,000 a month.

    It’s what the psychologists refer to as “selective perception”. You see what you want to see. You want to see a fifty fold increase in costs but you don’t want to see an eighty fold increase in income – because it sort of ruins the pleasurable feeling of righteous indignation.

    Last week-end I had a couple of hours to kill. Rather than mow the lawn, I thought I would focus my mind on the financial implications of inflation as applied to real estate investment.

    For the more fanatical readers, I am attaching below the spreadsheets which validate the conclusions. For the less fanatical, here are the results of my ruminations:


    Case study


    I assumed the existence of a commercial property that was generating an annual rental of $100,000 and that the value of the property was based on a “capitalisation rate” of 9% - ie the value of the property was $100,000 divided by 9% or $1,111,111.

    In my imagination, some buddies and I bought the building and I also made the following assumptions:


    1. 80% of the purchase price was borrowed from the banks. The remaining 20% PLUS A BUFFER of $55,000 to fund early working capital losses was financed by equity.
    2. The debt would carry an interest burden of 7% and would be repaid over 25 years.
    3. The cost of “managing” the building would be 1.25% of its capitalised value.
    4. Tenant rentals would escalate at 4% p.a.
    5. Tax at 30% would be payable on net profits, and there would be no tax benefits from depreciation.
    6. Any surplus cash would be paid to the shareholders as dividends.


    With the above as background, I created two imaginary scenarios:


    A) 100% occupancy rate for 10 years
    B) 100% occupancy rate for two years, followed by a 70% occupancy rate for four years during a recession, followed by 100% occupancy rate for four years.

    In the first scenario, the shareholder’s Internal Rate of Return (IRR) was calculated at 16.4% p.a. – not too shabby given the alternatives in today’s environment.


    But it was the second scenario that was fascinating. Here is what I found:


    1. The shareholder’s IRR fell from 16.4% p.a. to 13.8% p.a. – a still spectacular result
    2. From the bank’s perspective, it was actually BETTER off.


    Huh? Why would the bank better off?


    Well, because the recession occurred two years after we had bought the building, we had been able to pay off some debt. In turn, this justified a “deal” whereby we could pay “interest only” during the recession. Further, this also gave rise to a propensity of the bank to be able/prepared to re-lend us some of the original debt money against the security of the building. In turn this would subsidise our ability to continue paying our interest through the tough times.

    It needs to be understood that the banks focus primarily on “coverage” ratios. As long as the debt can be serviced out of income, and as long as the face value of the debt can be seen to be “covered” by the realisable value of the asset which it supports, the bank is more inclined to leave its loans out in the market place. Lending money is, after all, how they earn their living.

    Here is a table showing the two income streams from the bank’s point of view, with the left hand column showing interest income when the building was running at 100% occupancy, and the right hand column showing interest income flowing from our having to borrow more money when occupancy fell to 70%:



    Bank Interest
    Scenario 1 Scenario 2
    YR0 $ 62,222 $ 62,222
    Yr1 $ 59,733 $ 59,733
    YR2 $ 57,244 $ 57,244
    YR3 $ 54,756 $ 54,756
    YR4 $ 52,267 $ 54,756
    YR5 $ 49,778 $ 54,756
    YR6 $ 47,289 $ 54,756
    YR7 $ 44,800 $ 54,756
    YR8 $ 42,311 $ 53,566
    YR9 $ 39,822 $ 51,077
    YR10 $ 37,333 $ 48,588
    Total $ 547,556 $ 606,208

    In BOTH cases, the building was sold in year 10 – at a capital profit to the investors, and the outstanding bank loan was repaid in full.

    The fascinating insight was that as a result of the recession, the bank’s income ROSE!

    Of course, when you look at the world through the eyes of a bank, the critically important issue in the above equation is the existence of INFLATION.

    In both the above scenarios, provided rentals escalate by at least 4% p.a. both the investors and the bankers will be happy campers in the long run regardless of whether or not a recession manifests. (This will hold true just so long as a Depression can be avoided – because Depressions lead to deflation, and the whole house of cards could implode)

    The Federal Reserve System


    The harsh fact surrounding a Gold backed monetary system is that inflation is likely to be minimised and, if inflation is minimised, the above Utopian position cannot be realised. Of course, because Real Estate has a relatively inelastic supply, the price of real estate will always rise over the long term – provided population increases. The problem is that a recession is a natural outcome of the economic cycle, and economic cycles are themselves (collectively) an unavoidable natural phenomenon. If there was no inflation, then the inevitable recessions flowing from the inevitable economic cycles would cause bank incomes to FALL.

    So, flowing from the spreadsheets, it is crystal clear that the raison d’etre of the Federal Reserve System is to perpetuate inflation and, as long as incomes can continue to grow faster than expenditures, the quality of life will continue to improve.

    The critics of the Federal Reserve are therefore quite mistaken in at least one of their criticisms. The Fed is not failing in its attempts to minimise the negative impact of the economic cycle. It is succeeding. The core purpose of the Fed is to protect the integrity of the banking system. By engineering an inflationary financial environment, The Federal Reserve allows banks to survive/prosper in recessionary times when they would otherwise be threatened.

    Of course, if the banking system remains solid, then the economy can continue to power on. Yes, it is unfortunate that along the way some people will get hurt. Logically, however, many more people would get hurt if the entire banking system collapsed.

    It should also not be forgotten that the USA has been the engine of the World’s economy for generations. In simple terms, the wealth that is created in the USA has allowed the Fed to extend its reach internationally, so that via the IMF and the World Bank, the Fed is reaching out to protect the integrity of the banking system on a world-wide scale.

    But hang on a second! Before we get carried away, let’s examine the base assumptions:

    “Normal” people assume that when you borrow money you have to pay it back. The Federal Reserve System was not conceived with this assumption in mind. In fact, the opposite was assumed – ie that loans would NEVER be repaid in absolute terms. Even as one person (corporation or country) repays a loan the money is lent to another person (corporation or country) and the total amount of loans outstanding will ALWAYS rise. That, after all, is how banks earn their living. They charge interest on loans they make. They do not WANT the loans to be paid back. From a bank’s perspective the challenge is: How can we lend MORE money?


    The flaws in the reasoning


    Unfortunately, there is a flaw in the reasoning, (there is always a flaw in every seemingly too-good-to-be-true plan) and it is this:

    The debts can only be comfortably serviced if the interest burden – as a percentage of income – remains manageable. For the base assumptions of the Fed to hold true ad infinitum, the interest burden (as a percentage of income) should not pass the threshold of manageability. This logic applies both to corporate and Sovereign borrowers.

    The ability of Central Banks to create money out of thin air “co*ks a snoot” (love that expression) at one of the Achilles heels of humanity, namely greed. If Argentina, as an example, is unable to service its debts, it is much more likely that a greed motivated lender will be predisposed to paper over the cracks than it will be to recognise that sometimes, the core problems are incapable of being addressed by the borrower. Under circumstances such as these, the problems tend to multiply rather than go away.

    As a wildly generalised statement, the root causes are typically twofold:


    1. Corruption
    2. Market saturation within the “driver” economy.


    Corruption within the ranks of the borrower (corporate or Sovereign) give rise to a misallocation of resources – typically with a skew towards personal gain.
    Market saturation within the driver economy is what causes the Long Economic Wave to peak out and turn down.
    So it was bound to eventually manifest that the geniuses who gathered at Jekyll Island to conceive the Federal Reserve System missed the most fundamental issue, namely: “ceteris is never paribus”; everything else does NOT remain equal.

    All of which explains why Gold, ultimately, HAD to enter a Primary Bull Market, regardless of the jawboning, the dumping of inventories, and the selling of futures contracts. It was INEVITABLE that the Debt Service ratios – particularly of the Sovereign borrowers - would eventually reach (and pass) the point of no return. It was INEVITABLE that there would eventually come a time when there were just too many borrowers who defaulted on their loan servicing for the banks to paper the cracks any further.





    The approaching time started to become visible in mid 1999 when the gold price bottomed out after many years of trending downwards (see chart, courtesy TFC Commodity Charts)

    By the end of 2001 it became apparent that the Central Banks (led by the Fed) were losing control. In 2002, this was finally confirmed. Gold had entered a Primary Bull Market.

    Right now, as I see it, the Fed has two options:


    1. Drop the interest rates to near zero, to ensure that all loans remain performing (This will stuff their profitability, but not their solvency)
    2. Inflate the debt problem away, and then start again with a brand new currency that is not US Dollar denominated.


    Given that the Gold Price has been tracking commodities in general, the market is currently betting on inflation in general (as opposed to a shift towards Gold as a currency), but the Fed is not going to give up without a fight. Let’s see what happens to interest rates over the next few months. Interest rates hold the key. Will the Long Bond rate break up or down? If the Fed can manage both the dollar and the interest rates down, and Gold continues to track commodities, the situation is still salvageable. If the Fed can buy enough time, then the new “drivers” of the economy (Fuel Cells and High Temperature Superconductors) will eventually reach critical mass in the markets, and the economy can once again grow itself out of trouble.

    Time will tell, but I am not holding my breath. Usually after an Indian Summer comes a Winter of Arctic proportions. In my view, when the Indian Summer ends, Gold may very well morph from a commodity to a currency. With this in mind, I will be watching for a divergence between the commodity charts and the gold chart (Commodities down and gold up).

    If and when that happens, look out below! For the moment, it looks like we have a bit of breathing space.

    Brian Bloom

    Australia, May 6th 2002.





 
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