The federal reserve only has so many levers to pull and for the last year Bernanke has looked like a one man orchestra.  The main method for the Fed has always been the short term interest rate or Fed Funds rate.  Right now it stands at .25% but for all intents and purposes it is truly 0%.  Why does that have such a strong effect: because the banks can borrow at 0% and lend out to consumers at over 5% as money making machines.  In addition, it acts as a disincentive to savers.  Those who keep their money in money market funds or short term securities earn very little interest so they have an artificially created incentive to invest in risky assets.  Both of these facts lead to bubbles – investors plow money into markets and banks extend out credit everywhere and anywhere to bad borrowers.   At some point the tipping point is reached, the bubble bursts and we start this dance all over again.

The other rabbit that the fed pulled out of its hat comes in the rather vague term “quantitative easing”.  In reality, quantitative easing is nothing more than the federal reserve buying financial assets.  Why, pray tell, does the government buy financial assets?  In some sort of cockamamie scheme to lower longer term interest rates and again try to make banks lend out money.  The central bank basically prints money, puts that money into the economy, takes possession of the financial asset, and increases its balance sheet liabilities.

Now let’s think of the simplest example of this, which is the purchase of treasuries by the government.  Wait a second…the entity who issued the treasuries is going to print money so that they can buy the treasuries back in order to lower interest rates?  I know, it’s crazy.  The crazier part is that it actually does lower interest rates in the short term.  I think it’s a fractal.

The razor’s edge comes in the form of future central bank policies and subsequent inflation.  Regardless of current CPI levels, the Fed has effectively printed a boatload of money and put it out in the economy.  The reason that inflation has stayed low is because the velocity of money has fallen off a cliff.  Basically, most of the money is sitting on bank balance sheets because they are afraid to lend.  As soon as they start feeling better (which some have posited will be mid 2010) and start lending to consumers, the velocity of money will take off and inflation will rear its ugly head.  The central banks need to pull all of that excess money supply quickly in order to stifle inflation.  There is a caveat though, one that I pointed out in an earlier post:  The fed will not be able to sell all of the MBS (mortgage backed securities) to investors (about $1 Trillion in total) because under this scenario long term interest rates would be higher meaning that all of the MBS that the fed bought at 5% interest rates would be underwater in price.  That effectively means that in order to take that trillion out of the money supply the fed would have to take a loss on those investments which would effectively be a direct tax on the US Citizen.  I do not see that happening.

So the reality is that inflation will come eventually when the consumer steps back into the picture and I only view the consumer coming back when banks start lending again and this merry-go-round gets kicked into high gear.

What a tangled web we weave

As you can see the S&P has marched nearly lockstep with the increases in the open market purchases of treasuries, inverse of this you would see the drop in the dollar but I have shown that before (treasuries only being a proxy as they were buying many other financial assets along with a possible PPT purchase of S&P futures).