Why What The Fed’s Doing is Inflationary

by Aaron Krowne

With the Fed ramping up the “Quantitative Easing,” and now talking about potentially not limiting “round 2” or “QE 2.0” to $600 (or $900 billion if you include mortgage security run-off replacement purchases the Fed has promised), Bernanke is apparently doing a full-court press to convince the public that the Fed’s actions are not inflationary. He made an appearance on “60 Minutes” for December 5th, 2010, and made extensive comments to that effect.

This was covered in a good article just put out by my friend Tim Iacono, who makes apt points about the folly of the Fed’s rigged inflation metrics as any sort of guide. The crux of his article in my opinion is in this segment:

The fact is that the Fed is buying something quite tangible – Treasury securities – with something that they create with the simple press of a key and, while this may not have been such a big deal over the many decades that it took to buy the first $800 billion in U.S. debt, the thought of continuing to do this to raise their total holdings to over $3 trillion in a stretch of a little over two years is what really has people freaked out… No, this won’t cause high rates of inflation unless it gets out into the economy, but it could…

I think it is statements of this sort (in bold at the end) that are far too kind to the Fed.

Granted, one can hand Bernanke and his defenders a concession by admitting that indeed, the Fed is “sterilizing” its printing by sinking the money into bonds.    These sorts of operations keep “printed money” from “hitting the streets” immediately.  But such “sterilization” does not make the problem go away — statistics clearly show that increases in central bank balance sheets and “higher-order” money do eventually turn up as price inflation, in proportion to these earlier increases.

Even more specifically, my contention is that there is no question of whether the Fed is printing (or equivalent) with these actions — that the deed is done, and that further, the Fed is digging itself deeper by continuing QE.  The Fed not only can’t reverse “QE”, it cannot stop doing more.

To see why the Fed’s bond buying is ultimately inflationary, we can conveniently turn to Jim Rickards’ illuminating statements of a month ago:

Critics also raise the issue that this much money printing will result in inflation at best and maybe hyperinflation if velocity takes off due to behavioral shifts. The Fed is also very reassuring on this point. They say not to worry because at the first signs of sustained and rising inflation they will reverse course and reduce the money supply by selling bonds and nip inflation in the bud. But also note that the world in which the Fed wants to sell the bonds is also a world of rising inflation and therefore rising interest rates. This is the world of huge mark to market losses on the bonds themselves.

The Fed is saying don’t worry about mark to market losses because we will hold the bonds. The Fed is saying don’t worry about inflation because we will sell the bonds. Both of those statements cannot be true at the same time. You can hold bonds and you can sell bonds but you can’t do both at once. You will want to sell when rates are going up but that’s when losses will be the greatest. So the time when you most want to sell is the time when you will most want to hold. The Fed may say they can finesse this by selling shorter maturities only to reduce money supply and holding onto longer maturities. But that just further degrades the quality of the Fed’s balance sheet and turns it into a one-way roach motel for highly volatile and junk assets.

So, here’s the bottom line on money printing, or QE if you prefer. If nothing happens, the whole thing was a waste of time. If inflation takes off, the Fed will have to choose between holding bonds and letting inflation get worse or selling bonds and going bankrupt in the process. Since no entity goes down without a fight, the Fed will naturally hold the bonds and let inflation take off. Do not ask about the exit strategy from QE; there is no exit.

(John Hussman, another luminary in independent financial analysis, has also made comments to a similar effect.)

The upshot is: there is no way to back out of the Fed’s “QE.” It’s not only a bluff by the Fed, it’s mathematically impossible to get out without absorbing the losses — which is tantamount to printing the money to do so.  The only question is the timing; the end result is no longer in question.

What is going on now is that the market is figuring this out (particularly the US’s major creditors), especially since the Fed has continued to “kick the can” on its promised exit from its bond-buying programs, and instead is doing more of the same right in the creditors’ faces.

This is exactly what you would expect as the outcome if Rickards’ “Catch-22” holds: the Fed has no choice but to double-down.  It’s a huge “Monte Carlo” bet that can have no outcome other than destruction of the dollar.

The road can stretch on longer than most expect, as long as sufficient buying of Treasuries and holdings of dollars continues.  But those depended upon to do this buying are increasingly realizing where this road must inevitably — mathematically — lead to: inflation, devaluation, and possibly hyperinflation.