4 Ways the Federal Reserve Could Bring About Hyperinflation

No one wants to think that hyperinflation can happen in the United States, but it can. We’re all familiar with hyperinflationary crises in Weimar Germany, Zimbabwe, and numerous other countries around the globe. We may even be tempted to point and laugh at those simpletons who thought they could print their way out of a crisis. But isn’t that what the Federal Reserve is doing right now?

After ballooning its balance sheet from $800 billion to $4.5 trillion during the 2008 financial crisis and the years following, the Fed has pushed its balance sheet to over $7 trillion just within the past couple of months. If the Fed continues creating money at this pace, hyperinflation will cease to be a bad dream, and will instead become a potential reality from which investors will need to protect themselves.

So how could the Fed bring about hyperinflation in this country? It won’t be by accident – it will be the result of deliberate steps taken as a part of the Fed’s conduct of monetary policy. And here are four of the steps the Fed is taking right now that could send us down the road to runaway hyperinflation.

1. Monetizing Government Debt

Very often the most important step towards hyperinflation is the central bank monetizing government debt. Governments can only spend money if they have money. In days past, the gold standard provided a check on government spending. Governments could only spend as much money as they could redeem in gold. Once they reached the limit set by their gold stores, they couldn’t spend any more.

Today, with fiat paper currencies and electronic bank balances, governments have other constraints. They can raise money through taxation, they can raise money through borrowing, or they can raise money through inflation. Both borrowing and inflation often go hand in hand, and require the cooperation of the central bank.

If the government wants to spend trillions more dollars but doesn’t have sufficient tax revenues, it has to issue new debt. But if markets are saturated and don’t want any more government debt, the government has to pay higher interest rates. Enter the central bank, which purchases that debt directly, at lower interest rates.

Central bank purchases of government debt monetize that debt, as the debt securities are purchased with money that is created out of thin air. Whether it’s indirect purchases (purchasing government debt through intermediaries, often right after a debt sale) or direct purchases (purchasing directly from the Treasury), the more government debt the central bank purchases, the less fiscal discipline the government has to have.

If the central bank rolls over and acts as a rubber stamp, buying up every dollar of debt the government issues, then the government doesn’t have bond markets acting as a fiscal restraint anymore. Now the central bank is the sole buyer, purchasing every new bond issuance with money it creates from nothing. If the government doesn’t exercise restraint in making use of that power, hyperinflation can result very quickly.

Right now the Fed is monetizing much, if not all, of the government’s recent stimulus spending. The major risk is that if Congress feels it can spend as much as it wants since the Fed will pick up the check, Congress won’t feel the need to restrain its spending. And because the Fed wouldn’t dare say no to the federal government, since the Fed Chairman is a government employee, the stage is set for potential hyperinflation.

2. Expansion of the Balance Sheet

Expansion of the balance sheet right now is going hand in hand with government spending. But an expanding balance sheet doesn’t always mean that the Fed is bailing out the government. Sometimes it is bailing out private enterprise.

The Fed has currently created far more emergency lending facilities than it did in 2008. From financial markets to local governments to small businesses, there is hardly an area of the economy that the Fed isn’t ready and willing to bail out. It’s even planning to buy junk bonds, so determined is it to forestall another financial crisis.

But those bailouts come at a cost, namely the expansion of the Fed’s balance sheet. And the money that is loaned to businesses and governments comes from nowhere. Once it’s out in the economy, it’s free to run wild. There’s almost no chance the Fed will tighten the reins, so much of this balance sheet expansion will end up being permanent, increasing the money supply and leading to higher inflation. And the faster the money supply is increased, the worse inflation gets.

3. Eliminating Deposit Reserve Requirements

It isn’t just the Fed that can create money, banks can do it too. Bank deposits aren’t legal tender, but they’re accepted as being as good as cash in many financial transactions. Normally banks have had to keep at least a fraction of deposits on hand as reserves, hence the name “fractional reserve banking system” given to our current system of banking.

Normally the Fed sets reserve requirements at 0-10%, with larger banks being required to hold 10% reserves and only the very smallest banks not being required to hold reserves. Now all banks can hold zero reserves since the Fed has lowered required reserves to zero for all banks.

That means that all banks can now create new deposit accounts out of thin air should they wish to do so. Many may not take full advantage of the new lowered requirements, but very many may decide to draw down reserves, loaning out more money and setting inflation into motion. Theoretically, a banking system with no reserve requirements could create an infinite amount of money. And that, of course, would result in hyperinflation.

4. Not Neutralizing Money Injections

There were fears of hyperinflation in 2008 too, but those never materialized. That was because the Fed largely neutralized its monetary injections by paying banks interest on excess reserves. Just about every dollar the Fed added to increasing the monetary base was matched by a corresponding increase in bank reserves. Therefore, even though the monetary base exploded, it didn’t result in hyperinflation.

This time around the relationship isn’t 1:1 anymore. So far about 87% of the Fed’s monetary base injections have been neutralized through higher bank reserves. If that figure drops, and if banks begin drawing down reserves, then there’s a real chance that inflation will break out and, in a worst case scenario, hyperinflation will ensue.

The key to this is the interest rate the Fed pays on excess reserves. Banks were previously all too willing to take a small interest gain rather than risk losing money that they loaned out. But what happens if the Fed decides to take interest rates negative? And what happens if the interest rate paid to banks goes negative? Then banks will have to pay the Fed for their excess reserves. And the result could be that banks drain their excess reserves, pushing all those trillions of dollars sitting on the sidelines out into the banking system to work their inflationary mischief.

We’re Not in 2008 Anymore – This Time Is Different

The key thing investors need to realize is that we’re not in 2008 anymore. This time things are different. Even though the Fed is following a similar playbook to 2008, it’s expanding its scope of lending and drastically accelerating its pace of money creation.

Many investors learned their lesson in 2008 and afterwards, especially in seeing the performance of gold and silver versus stocks during that period. They vowed not to get caught out again should something similar happen in the future.

Well, now that something similar is happening, only this time it could be much worse than 2008. And investors who haven’t been investing in gold, silver, and precious metal assets that could protect their assets stand to lose even more than they did in 2008, particularly if the Fed’s actions or miscalculations result in hyperinflation.