Inflation, the third certainty

From Colin Twiggs, The Patient Investor, 25 March 2025

In this world nothing can be said to be certain, except death and taxes. ~ Benjamin Franklin

That may have been true in 1789, but since President Richard Nixon ended the dollar's convertibility to gold in 1971, we live with a third certainty: inflation.

Ending convertibility to gold lifted the restraint on central banks to limit the creation of new money; otherwise, they would face a run on their gold reserves (or USD reserves linked to gold).

This resulted in a rapid decline in the dollar's value. Today, the dollar has the same purchasing power as 9.2 US cents in 1960.

There have still been brief periods of deflation, most notably in 2009 during the global financial crisis.

But central banks are well aware of the danger. The 1929 Wall Street crash and subsequent banking crisis caused a deflationary spiral as money in circulation contracted.

Whenever prices threaten to deflate, the Fed swiftly expands the money supply to counter the contraction. The graph below shows the rapid expansion of the monetary base relative to GDP after the 2008 global financial crisis and during the 2020 COVID pandemic.

While inflation is inevitable, its rate varies and is determined by various factors, including money supply growth, wage rates, oil prices, and other external shocks.

The globalization of international trade introduced a new form of deflationary supply shock, especially after China joined the WTO in 2000 and was granted favored nation status by the US Congress. Low wages, industrial subsidies, and low health and environmental standards enabled the new entrant to undercut industry in developed economies, flooding international markets with low-priced manufactured goods.

Central banks pushed back with fiscal deficits and monetary expansion to soften the impact on their economies. Unfortunately, the stimulus flowed to the top 10% while the bottom half bore the costs.

Globalization in reverse

We now face a new challenge: the reversal of globalization through increased tariffs and other trade barriers.

According to Stephen Mirran, Donald Trump's chief economic adviser, tariffs on imports will offer three main benefits. First, tariffs are a new source of tax revenue, enabling Congress to reduce corporate and individual tax rates and stimulate economic growth. Second, tariffs increase the cost of imports and encourage investment in domestic industries while imports decline. Third, the real clincher is that foreign exporters are forced to absorb the cost of the tariff, not the US taxpayer.

It doesn't quite work like that.

The first benefit will only occur if trading partners don't retaliate with their own tariffs. Second, imports will only decline if the dollar doesn't strengthen as it did in 2018.

Third, foreign exporters will only bear the cost of the tariff if the dollar strengthens and imports don't decline—the last two benefits conflict. The more imports decline, the more the US consumer will bear the cost of tariffs instead of foreign exporters.

Why we are concerned about inflation

A Weak Dollar

The dollar has weakened considerably since the announcement of tariffs. The administration's on-again-off-again tariff policies have raised uncertainty and reduced growth expectations, causing a 50-basis-point fall in the 10-year Treasury yield and a similar decline in the Dollar Index.

The weaker dollar should ensure that US consumers bear the cost of the tariffs, and even the prices of goods not subject to tariffs will rise.

Trade War

Retaliatory tariffs by trading partners are likely to increase the cost of imported goods to US consumers, especially if the dollar weakens.

The best way to minimize retaliation would be to implement tariffs gradually and quietly, or pretty much the opposite of what has happened so far. ~ Joseph Calhoun

Higher Domestic Prices

US consumers will also likely pay higher prices to domestic producers who would be uncompetitive without the tariffs.

Recession

A trade war would likely cause a recession, pushing the Fed to cut rates while falling tax receipts would increase the fiscal deficit. A recession would initially ease inflation, but increased deficits and stimulatory measures by the Fed would likely increase inflationary pressure over time.

Fiscal Dominance

The dollar is weakening as its status as the global reserve currency diminishes, as evidenced by the soaring gold price.

Foreign purchases of US Treasuries are declining as a percentage of GDP, which has increased upward pressure on yields.

The Fed will likely attempt to suppress long-term rates by opening up new sources of demand for Treasuries. While further Treasury purchases (QE) by the Fed are unlikely, they may attempt to achieve a similar result by relaxing the supplementary leverage requirement for Treasuries. With no SLR constraint, commercial banks can leverage Treasury purchases to infinity. This would make UST an attractive investment for commercial banks and has been done before, in 2008, to boost commercial bank support for Treasury markets.

"We might actually pull treasury bill yields down by 30 to 70 basis points. Every basis point is a billion dollars a year." ~ Treasury Secretary, Scott Bessent

After the Silicon Valley Bank (SVB) debacle, commercial bank demand will likely focus on T-bills without much impact on the long end of the yield curve.

Bank purchases will effectively swap bank reserves at the Fed for T-bills to be held on their balance sheets, cutting out the Fed as the middleman. With QE, the Fed typically pays for Treasuries purchased by crediting banks with increased reserves, which are a liability of the Fed, and holding the securities as an asset on their balance sheet.

This does not expand the money supply and is not in itself inflationary. However, increased reliance on the Fed and commercial banks to fund the government increases the risk of fiscal dominance.

Fiscal dominance is when a country's debt and deficit are so high that monetary policy focuses on keeping the government solvent instead of controlling inflation. ~ Simplicable

Inflation: A Soft Default

The $36 trillion in US federal debt is too large to be repaid.

Debt reduction would require reversing the current fiscal deficits of $1.5 to $2.0 trillion to a surplus of at least $1.0 trillion. The shock to the economy would cause a decades-long recession similar to the UK after WWII.

Treasury Secretary Scott Bessent on reducing the deficit:

I was with one of the congressional budget committees two weeks ago, and they really want to cut this fast. And I said, you do realize every 300 billion we cut is about a percentage GDP, so you, we are trying to land the plane.

Long-term austerity is most unlikely, and the only viable alternative is to inflate the debt away, boosting nominal GDP to the point that the debt ratio to GDP declines to about half its current level.

Conclusion

China and the EU, the US's two biggest trading partners, will likely retaliate if it increases import tariffs. They will also likely withdraw investments from US financial markets over time. This is expected to drive up inflation and long-term interest rates, leaving the Fed with a stark choice. Fiscal dominance means that the solvency of the Treasury is likely to be prioritized over inflation. Especially after May 2026, when the current Fed chair's term ends, he will likely be replaced with a more pliant Trump appointment.

Inflation is inevitable. Buy gold and defensive stocks on reasonable earnings multiples. Avoid high-multiple growth stocks and long-term Treasuries.

Acknowledgments

• Luke Gromen, FFTT: March 21, 2025
• Joseph Calhoun, Alhambra Partners: A Risky Plan
• Simplicable: Fiscal Dominance
• Federal Reserve of St Louis: FRED Data