Inflationary Depression - A Possible Scenario

 April 28, 2010

US economists are quickly diverging into two groups: those who believe that the economy is in a V-shaped recovery and those that believe that the economy is in a U or L shaped recovery.  Unfortunately, this absolutist form of thinking does not leave open the possibility that a third type of economic scenario is unfolding.  What if all the pundits were wrong? 

Below, we lay out a possible “Inflationary Depression” scenario.  The following are key tenants of such a possibility.

1.       Q2 2010 earnings and economic expectations do not meet analyst forecasts.

2.       Equity indices start to decline.  Investors rush to US Treasuries and the dollar.

3.       Asset prices across the board decline significantly, including commodities, precious metals and energy.

4.       Concurrently, media, economists and politicians begin a big push toward enacting round two of quantitative easing and additional fiscal stimulus.

5.       US equity markets stabilize.  The US dollar resumes its fall.

6.       Other countries, in an effort to stave off increasingly unsustainable inflation in their economies are forced to begin raising interest rates resulting in appreciation in their currencies against the US dollar.

7.       The U.S. government gets caught in a “Catch 22”: A.) Defend the dollar and raise interest rates or B.) Let the dollar collapse.

8.       Because of bitter divisions between the political parties, the U.S. Treasury and the Federal Reserve a quick and unified decision does not come (fiscal and monetary policies coming together).  Likely, the Federal Reserve wants to raise interest rates, congress want to continue heavy deficit spending.

9.       As inflation grows exponentially worse, over the ensuing months, asset prices melt up in price, creating asset prices across the board.

10.   Finally, the Federal Reserve breaks ranks and starts raising interest rates.  However, in an effort to preserve the asset bubbles they helped create, they include moderating language with their increase, temporarily soothing the markets and preventing a wholesale liquidation of assets across all classes.

11.   However, the Fed’s attempt to gradually raise interest rates over a prolonged period of time does little to quell inflationary fears.  Unfortunately, at this point in time, inflation has already become entrenched and pervasive throughout the economy.

12.   Worse yet, continued deficit spending by the U.S. government negates any moderating influence gradual rate increases have. 

13.   Ultimately, in an effort to quell the continued deterioration in the dollar and to stop further inflation growth, the Federal Reserve is forced to dramatically increase interest rates in a short period of time. 

14.   The result is a simultaneous popping of numerous asset bubbles, most notably US Treasury Bonds and Bills.

15.   The resulting explosion in US Treasury Bonds finally forces Congress to dramatically and rapidly cut spending across the board.  Unfortunately, the spending cut is coupled with a one-time devaluation against the Chinese Yuan and other Asian currencies.

16.   The years that follow show a U.S. economy beset by a massive depression, forcing the economy to painfully rebalance itself towards a new reality of little credit access, massive consumer savings, very high unemployment and depressed GDP.

In summary, such a potential scenario could play out.  In order to avoid activating such an economic catastrophe, the relevant involved players will need to operate in a fashion that goes against their typical reactions to events.  Forcing people to change their behavior and reflexive response is difficult, even during less stressful times.  Will these individual economic actors collectively summon the courage to put a uniform foot forward?  If the current events unfolding within the European Union are any indication, readers should not hold their breath.