Fed Chair Kevin Warsh promises 2% inflation, but skyrocketing U.S. debt makes that a pipe dream

By Brett Arends

Uncle Sam needs inflation, not just economic growth, to escape today's debt crisis

Fed Chair Kevin Warsh says he wants to get inflation back down to 2%. But can Uncle Sam afford it?

Kevin Warsh, the new chairman of the Federal Reserve, vows that he's going to do his darndest to bring inflation back down to the central bank's official 2% target. "Let me reiterate: There is no soft inflation target. There is no soft implicit target. Not on this committee's watch," he said during his press conference on July 29. "There's only a target, and it's 2%."

Wall Street seems to believe him. Right now, based on the differential between the interest rate on Treasury bonds with inflation protection and Treasury bonds without inflation protection, the Street is expecting inflation to average about 2.25% over the next decade - meaning it expects the Fed to bring inflation down to around 2% and keep it there (with a pretty modest 0.25% margin of safety).

To which the thinking investor might reply: Good luck with that.

For context, inflation has averaged 4.2% over the past five years. Prices have risen 3.5% in the past 12 months, and analysts are expecting that to slow hardly at all when the U.S. Department of Labor publishes new data Wednesday.

Anyone planning their finances, and especially planning for their retirement, should take these sunny expectations with a fistful of salt and include a much higher margin of safety in their plans in case of higher inflation. What would your plans look like if inflation averages 3% in the coming decades? What about 4%?

The reason is the skyrocketing U.S. national debt, the systemic inability of the U.S. political system to address it and the inevitability of a reckoning coming sooner or later. As someone wise once said, if something can't go on forever, it won't.

The reason I'm returning to this topic right now is because of the persistent, and infuriating, half-truths and outright lies about the debt being spread by Wall Street hucksters. The argument that "the debt won't be a problem because it hasn't been so far" is so stupid, I'm not sure how much time to waste debating it.

By that logic, you're never going to die, because you haven't yet.

The gross national debt stood at about 55% of gross domestic product at the start of the millennium and at 62% in 2007, just before the global financial crisis. Today? Oh, 120%.

The more dangerous argument is that the debt won't be a problem because America has been here before - at the end of World War II, when debt also reached about 120% of GDP. And, says the sunshine crowd, the U.S. simply "grew" out of the debt trap through rapid economic expansion.

This is balderdash.

The U.S. escaped this massive debt trap last time only with the help of enormous inflation. Between 1945 and 1981, inflation averaged 4.7% a year. Meanwhile, 10-year Treasury notes- the benchmark U.S. government bond - paid out an average of only 2.8% a year.

In other words, the federal government escaped its monumental World War II debt trap by (legally) stealing from the people foolish enough to lend it money. On average, when measured in real purchasing-power terms, bondholders lost about 2% of their money a year. Between 1945 and 1981, their cumulative losses in real terms were about 50%.

Thanks to the inflation that was ignited during the war, pretty much everyone who bought those 10-year Treasury notes between the mid-1930s and the mid-1970s and held them until they matured - in other words, held them for 10 years - ended up losing money in real terms. Running the numbers, I find that between 1932 and 1974, real returns were actually negative in about three-quarters of 10-year periods, and below 1% a year in almost all the others. Once you deduct fees and taxes, someone earning 1% a year or less on bonds in real terms was probably not left with much, if any, actual profit. The best 10-year performance over the entire period was from 1956 to 1966, and that amounted to just under 1.2% a year in real terms.

Booyah!

It's also worth pointing out that the U.S. political system after World War II had not yet degenerated to the levels of imbecility we have today. As a result, another reason the federal government was able to climb out of its debt hole was more prudent budgeting. In seven out of the 13 years between 1947 and 1960, the federal government actually ran a budget surplus. Despite the Korean War, the biggest deficit in the period was 1.7% of GDP.

Such restraint today seems as quaint as poodle skirts and "I Love Lucy." Last year, amid peace and low unemployment, federal deficits were 5.8% of GDP, and they are likely to be higher than that this year. The Congressional Budget Office expects them to rise to nearly 7% of GDP by 2036, at which point gross national debt is expected to be around 140% of GDP.

So the last time debt was this high in relation to the economy, the Truman and Eisenhower administrations tried to do something to start paying down the debt. This time? We're going to borrow even more.

You can see why Wall Street salesmen are lying to you.

Inflation-protected U.S. Treasury bonds, or TIPS, which did not exist before the late 1990s, let you lock in real interest rates as high as 3% a year. I've written about them frequently and I own them myself. One issue with these is that you wouldn't expect them to be spared from the, ahem, "market volatility" if and when the bond market wakes up and starts to ask serious questions about the U.S. national debt. Most of the financial experts I talk to, including many of the pessimists, reckon TIPS will be all right if you hold them to maturity, even if they can't escape price volatility along the way.

And what if the worst happened, and the U.S. government actually ended up imposing any official "haircut" on Treasury bonds, paying out less than 100 cents on the dollar even in nominal terms? I suspect the panic in the Treasury market would be nothing compared to the panic in pretty much everything else. But of course, this is just a hypothesis - or, as they say outside Wall Street, a guess.

-Brett Arends

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