The Volcker Gambit

Way back in 1980, the (Paul) Volcker Fed jacked up interest rates to record highs in order to extinguish 1970s commodity induced inflation. Eventually inflation started coming down again and the Fed lowered interest rates in lockstep with the decline in inflation. But a funny thing happened in 1981 - inflation started heading higher again. The Volcker Fed was forced to make an abrupt u-turn and begin raising rates again. In the event they pushed the economy into the worst recession of the post World War II era, at 10% unemployment.

A similar dilemma confronted the Bernanke Fed in 2008 which was facing a rising CPI due to sky-rocketing commodity prices. However, they were spared having to raise rates by the fact that global markets collapsed. Therefore, I showed the chart below yesterday (Tuesday) on Twitter which predicted a rising CPI today due to soaring commodity prices deja vu of 2008.

And then we got this headline this morning (the chart shows the newly updated CPI at 3%):

It's looking more and more like the interest rate cuts in 2024 were a Fed policy mistake that will force them to make an embarassing Volcker u-turn. Barring a market crash sooner than later.

Unfortunately Trump doesn't understand monetary policy (or fiscal policy) so he put out this badly timed message just prior to CPI:

If the Fed lowered short-term rates now, long term interest rates would soar due to rising inflation expectations. This is something that Trump's Treasury Secretary Scott Bessent clearly understands, but he has been unable to explain it to his boss. Bessent knows that unless the deficit is reined in then long term rates are going higher.

So far, the "DOGE" cuts made by Elon Musk have "barely made a dent" in the U.S. budget deficit which is projected to be over $2 trillion again this year. Recall that during his first term, Trump massively increased the deficit due to his tax cut and then of course the unexpected pandemic.

Now everyone is saying that the Treasury needs to cut the deficit or the U.S. will be "bankrupt" sooner than later. Pundits have been predicting this for years, but when a country issues debt in its own currency, the key risk is not bankruptcy it's hyperinflation. The U.S. will never be forced to default on its own debt when the Fed can monetize the deficit. However, in Japan which has been monetizing their deficit for decades their national debt (% of GDP) is twice the size of the U.S. and yet they have the lowest inflation in the world. Why? Because they have been importing deflation from the rest of Asia. Lately due to the weak Yen, inflation has been creeping up and so the BOJ is now raising rates to quell inflation.

Therefore, it's highly ironic that the BOJ will be the most likely catalyst of global financial meltdown as the hot money they have issued over the past 30 years force unwinds at record pace due to their efforts to reduce inflation.

In summary, there is only one way to get inflation down quickly, and Trump is right, more trade war could be the answer.