In the words of Benjamin Franklin: “In this world nothing can be said to be certain, except death and taxes.” Based on the recent actions of the US government, it looks like inflation will soon be added to this list of certainties.

Fiscal policy is defined as the use of government spending and revenue collection to influence the economy. The two main instruments of Fiscal policy are government spending and taxation. Monetary policy on the other hand, is the process by which the government or central bank controls the money supply, availability of money, or cost of money, with the objectives of influencing the growth and stability of the economy. In the past, the Federal Reserve (Fed) has controlled the monetary base by raising or lowering the target rate. A lower target rate increases the ability of commercial banks to borrow from the central bank, expanding their balance sheets and increasing credit available to the economy. More recently, with the target rate between 0 per cent and 0.25 per cent, the primary tool used to control the monetary base has become the open market operations or “quantitative easing”. This is the purchase and sale of second hand government debt by the Fed.

With the theory out of the way, we can now turn to the actions of the US government over the past 18 months and what the consequences of these actions might be.

Estimates are that the US will have a $2 trillion budget deficit this year as a result of the various stimulus packages as well as an increased Federal burden from social security, Medicare and Medicaid. The Congressional Budget Office estimates that the US will post deficits in excess of a trillion dollars in each of the next 10 years.

The two burning questions are; who is going to fund these huge deficits, and how will this debt eventually be repaid?

In order to fund their ongoing expenses, the US government typically issues treasury bills. In 2009 the US will need to issue almost four times the amount of debt compared to 2008. A large portion of this debt is purchased by foreign buyers. These foreign buyers, and in particular China, are becoming more discontented with the US government by the day. They are concerned over the level of debt being issued as well as the stability of the US dollar going forward. So who else can buy this debt? (This is where the Fiscal and Monetary policies overlap). The Federal Reserve becomes the buyer of last resort through their policy of quantitative easing.

The debt burden can be borne directly by the American taxpayer, which is highly unlikely in the current political landscape. The only alternative is through inflation, by printing money. A dollar of debt tomorrow is less than a dollar of debt today. This is exactly how the Fed is paying for their purchases of treasury bills. The attached chart shows the level of money supply going back to 2000 with a notable spike in the middle of last year. Do they have the ability to withdraw this money supply when the time comes?

Cayman’s economy is explicitly linked to the US. Our exchange rate is pegged to the US dollar, our Prime rate of interest is linked to US interest rates, and most of what we consume is imported from the US.

In the near term, we are facing deflationary pressures, primarily as a result of the imbalance between the supply and the demand of consumer goods. Demand is falling faster than supply. The problem facing the US consumer, and indirectly, everyone here in Cayman in the longer term, is the inflationary pressures on the horizon as a result of the monetary policy in the US. With high levels of inflation, just as today’s debt is worth less tomorrow, so will today’s savings be worth less tomorrow. The value of our savings will decrease in an inflationary environment.

How can we protect our savings? Gold has always been considered a good inflationary hedge. This can be played through an Exchange Traded Fund (ETF) which mirrors the movement in the gold price, such as GLD, or alternatively an investment in an ETF which tracks the gold miners themselves, such as GDX, which has underperformed the gold price since the beginning of 2008. Alternatively diversifying your assets out of U.S. dollars should be considered. Again, this can be done through an ETF which mirrors an underlying market, such as EEM (Emerging Markets), EPP (Asia Ex-Japan) or BKF (Brazil, Russia, India and China).

 

Disclaimer: The views expressed are the opinions of the writer and whilst believed reliable may differ from the views of Butterfield Bank (Cayman) Limited. The Bank accepts no liability for errors or actions taken on the basis of this information.

 

Mark-Fagan-Colour

Butterfield Bank’s Mark Fagan

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