Soak it up

So the Federal Reserve has officially unveiled the next round of quantitative easing. For those of you following this blog you will recall that I called that back in August (see blog on 8/10/2010). Well now it is official. Another $600 billion to start and maybe more later. On the announcement the market went berserk and volatility spiked, but at the end of the day the market ended up and most commodities spiralled higher as the dollar plunged.

The Federal Reserve is intent on "bailing" us out of this mess by driving the dollar lower. A weak dollar will strengthen exports. It will also have the effect of creating inflation as pretty much all commodities are traded in dollars. This will feed into the economy and inflation will start to surface sooner rather than later. For now however the Federal Reserve believes that more stimulus is needed (correctly) and that this can be achieved through continued money printing (incorrect).

The reason that they believe this is they feel that they "have the tools" available to soak up the money printed when there is any threat of inflation. What a joke! They cannot, have not and will not ever get that right. The methods for soaking it up are so arcane and so politically sensitive that it will never work. Let's look at this in terms of a scenario.

Inflation appears, gradual at first, but then it starts to accelerate. The cause of the inflation is two fold, too much "stimulus" cash in the system and a weak dollar. So let's start to soak it up. First we will deal with inflation by raising rates. Ouch that will hurt. Goodbye housing and the consumer who will now have to pay more for their debt. This will choke off any kind of recovery and cannot be done until we have a vibrant economy with strong employment.

Next we will start to sell off some of the government held debt (most of it junk). This will drive rates even higher and will reduce an already anemic rate of money velocity. Essentially the two methods combined will drive interest rates to excessive levels, choking off the recovery and driving the US economy into another recession.

Alternatively they could just let inflation spiral out of control but they will never let that happen without a fight. The Federal Reserve has at is core the mantra to fight inflation at all costs. Their ability to contain inflation within a target range is anything but stellar so I expect that as in the past they will wait too long to turn off the spigot. This will result in inflation will accelerating well above their target level of 2.5%. Not that controlled inflation is a problem it is uncontrolled inflation that can derail an economy.

So can they soak it up? Not a chance. Will their current policies end in failure? At this juncture there is a very high probability that another recession will be upon us within the next twelve months. Prepare yourself and your portfolio accordingly.