The Federal Reserve has created a doom loop between the housing market and inflation. For years it has printed tens of billions of dollars each month to buy sketchy securities meant to subsidize the housing market and favor bond traders. This continues even now, in spite of inflation and a red-hot housing market. But the housing market has become dependent on unearned, newly printed money, and stopping the flow might cause a catastrophic correction. If it doesn’t stop, however, inflation will explode. 

Let me walk you through some of the math.

You think 8 percent inflation is high? Prices need to double to restore any semblance of balance between currency and the things you can buy with currency. We have a long way to go.

To understand how dire the situation has become, we need to review a curious practice the Fed began shortly after the 2008 crash. In November 2008, the Federal Reserve began an extraordinary program of purchasing mortgage-backed securities (MBS) Using newly created money (not tax dollars or private investments), the Fed dumped billions of dollars per month with the stated goal of helping the government stimulate the economy. 

A mortgage-backed security is simply a pool of mortgages. As homeowners pay their mortgages, the money then flows to bondholders. The 2008 financial crisis resulted from problems valuing these securities. In order to sell a MBS, the buyer had to gain some confidence in the likelihood of repayment. Because this involved so many complex and unknowable factors relating to each of the individual mortgages, the debt could sometimes turn “toxic” or drop in value quickly when buyers lost faith in the future performance of homeowners. 

The sheer scale of the Fed’s involvement in the mortgage market caused an unstable bubble. As the president of the Kansas City Fed recently said, “by owning roughly one-quarter of the MBS market along with a significant portfolio of longer-term Treasuries, our presence in financial markets muddies price signals, encourages excessive risk-taking, and can foster financial instability. Asset prices remain historically high and remain vulnerable to economic and policy uncertainty.” 

In other words, lenders don’t need to worry about lending to risky borrowers because the Fed is buying all the crap nobody else will touch.

Although the Fed promised it would stop buying mortgage-backed securities by March of this year, the promise came with a giant asterisk. As old bonds mature and disappear from its balance sheet, “monthly purchase schedules will continue to be issued to reflect reinvestment of principal payments . . .” In other words, when the Fed receives a dollar from an MBS payout, it just uses it to buy another bond. 

Thus, in the face of red-hot inflation, the Fed bought another $38 billion in mortgage-backed securities in March. In April, it bought another $40.1 billion. This month, the Fed is in the process of buying another $34.5 billion. 

So all of this might seem like terrible news. But it’s nothing compared to the doom loop that has begun to turn. The coming reckoning could be savage and apocalyptic. Let’s walk through what might happen next.

The problem with inflation is not just how high it is, it’s how quickly it is increasing. Again, the money supply has increased so much that prices would have to almost triple to restore balance between goods and the dollars chasing them. So the Fed’s mandate requires it to intervene to stop inflation. It typically does that by raising interest rates and selling back its bonds. When the Fed sells a bond, the cash flows out of the economy relieving the inflation pressure. 

To fight inflation, interest rates need to exceed the inflation rate. That means a dollar saved loses purchasing power unless savings interest rates climb from less than 1 percent to something over current inflation (now around 8 percent). One rule of thumb provides that savings interest rates should reach 150 percent of inflation in order to reverse the trend. The theory holds that high interest rates encourage saving cash thus slowing down the speed at which money chases assets. If interest rates are less than inflation, it makes holding cash a losing proposition.

But in this environment, raising interest rates will cause a cascade of problems. The higher interest rates will slow the economy and cause unemployment. It will also swallow up tax revenue as the government has to pay interest on its massive debt. But more critically, it will increase the rate of default on home mortgages. Those defaults will make mortgage-backed securities less valuable and more unpredictable. That’s how the 2008 housing market seized up. 

Thus, the doom loop. 

The more the Fed props up the mortgage industry, the more it encourages inflation. The more inflation increases, the more urgent it becomes to stop printing money. When the printing press stops and interest rates rise, those MBSs likely will turn toxic again, freezing the market at the exact moment the Fed needs buyers for its bonds.

Closing the gap between money earned and money spent means cutting government spending, raising interest rates, reducing regulation, and lowering taxes. Government can and should facilitate increases in productivity by reducing its interference in every private transaction. More Americans get a check from the government than pay taxes. The labor participation rate is dangerously low. There just aren’t enough people pulling their weight to make the things needed to sop up all of this excess money. 

Even communist countries have resorted to my suggested reforms when markets smash their utopian plans. But no communist was ever as dedicated to economic suicide as the current class of idiots who rule us.