The Classic Liberal Blog

Regular readers of this blog, know that I've been warning of severe inflation for a long time now. Yet these warnings seem difficult to believe. Especially considering that the mainstream keeps declaring the opposite: "Economists expect no hyperinflation!"

So the question remains ... Will there be severe inflation? Or not?

First, let's quickly review the definition of inflation:

One price or several prices rising is not inflation. Increases in money supply are what constitute inflation, and a general rise in prices is the symptom. As the late Nobel Laureate Professor Milton Friedman said, "(I)nflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output.

The above definition of inflation was provided by Dr. Walter E. Williams, John M. Olin Distinguished Professor of Economics at George Mason University, and is as good as any definition you'll find - Inflation is an increase in the money supply.

Our Bailout Economy

In 2008, the Bush administration embarked on an unprecedented mission to inflate our way out of financial disaster. Then in 2009, the Obama administration not only ran with it, but put it on steroids!

We're not going to rehash the particulars of the programs here, but if you'd like a quick refresher, read John Stossel's "Government Sets Us Up for the Next Bust."

For now, just consider this one quote:

The Fed had given up trying to make it easier for banks to lend to each. Now, the Times reports, it "is directly subsidizing lower mortgage rates ... doing so by printing unprecedented amounts of money, which would eventually create inflationary pressures if it were to continue unabated."

Okay, okay, the Federal Reserve has been printing money. But where's the inflation you keep warning about?

The inflation is the increase in the money supply that was created by the Federal Reserve's printing press. So how does this affect you?

Inflation Rising

Have you been to the grocery store lately? Because as Jim Rogers already pointed out, inflation is already here!

Take a peek at the latest headlines:

• Surging costs of groceries hit home
• Gas prices increasing, could hit $3 per gallon in May
• Report: Wal-Mart food prices going up

One of the reasons that the governments massive bailout scheme didn't immediately hurl the American economy into a Weimar Republic disaster, is because the bailed-out banks were hoarding their cash.

Banks haven't loosened up on their lending either, so it would seem that they'll continue doing just that ... thus holding off a massive wave of inflation.

Unfortunately, the banks have started to spend those massive reserves (stolen from the public), buying U.S. Treasuries!

Banks May Not Be Lending, But They Are Buying Treasurys

Surprisingly strong Treasury auctions in March had help from banks, which normally stay away from such events.

Banks snapped up $5.7 billion of the total $34 billion auctioned in 10-year notes and 30-year bonds, providing demand for auctions that many analysts thought would flop. The auctions occurred as inflation fears began to grow and amid signs that investor appetite for the massive supply of government debt was beginning to wane.

"The pattern suggests that banks have been starting to put their large cash balances to work, but is not an indication that bank balance sheets as a whole have started to grow," Deutsche Bank said in a research note.

The suggestion is that banks are using Treasurys as a way to get some return on their money that they might otherwise reap from making loans.

That banks would get so involved with long-dated securities came as additional surprise since they aren't usually such active participants at auctions and generally buy mostly short-dated notes. Under normal circumstances banks don't have much interest in keeping long-term rates low as that could compress the yield curve and cut into the profits they could make on lending.

Yet combined with their purchase of agency-backed debt such as mortgages and student loans, banks bought a total of $40 billion from the Treasury in March, according to analysts at Deutsche Bank.

The banks spent $40 billion buying government debt. So what?

Well, according to the Federal Reserve, excess bank reserves decreased by about $41 billion in March. In other words, a lot more of that freshly printed (out of thin air) money is seeping into the markets. Meaning inflation is going to continue to get worse.

Keynesian Alchemists

So besides the obvious, that banks want to earn more money, why else could they be buying Treasuries?

But there's also another less-obvious reason banks could be stepping in to the Treasury market: A type of tacit quid pro quo with the Federal Reserve to keep short-term rates low by helping the government finance its debt through Treasury auctions.

Art Cashin, director of floor operations at UBS, noted after the 30-year auction suspicions among traders about who was doing the buying. In remarks to CNBC, he spoke of "all manner of conspiracy theories floating around. Is the Fed putting on a fake moustache and a raincoat and coming in as an indirect buyer?"

"Banks are stealing money from the public, giving consumers zero percent interest on deposits, and instead of turning over risk to the over-indebted consumers, they're loaning money to the government," says Michael Pento, chief economist at Delta Global Advisors in Parsippany, N.J. "I'm sure it's at the behest of (Fed Chairman) Ben Bernanke—we're going to keep rates low but you must facilitate the Treasury auctions going off smoothly."

The Fed funds rate is near zero, meaning that banks can borrow at almost no cost and lend out at the prevailing rate—or invest in vehicles such as Treasurys.

The 10-year yield edged over 4 percent in the days after the weak March auction for the benchmark note but has fallen precipitously since then, trading around the 3.75 percent area and helping to keep government borrowing costs down.

Strange days indeed.

Don't get caught with your pants down. Be prepared for the inflation ahead!