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Fed Creates Nightmare Scenario, Closes Eyes, Sings Trololo

The Fed today elected to print an additional $45 billion a month via outright purchases of Treasuries. That’s in addition to the printing of $40 billion a month via MBS purchases that it is already doing. It will also continue to reinvest the proceeds of maturing MBS. That’s been running at $35-$40 billion per month. At that rate the Fed will be pumping at least $120 billion per month into the trading accounts of the Primary Dealers. This total is as high as during QE 1 in 2009. The dealers will use the cash to purchase more Treasuries, which will partly fund the Treasury debt. Other buyers will continue to fund the rest.

The dealers will also deploy the cash in other trades, including some MBS purchases in addition to the Treasury purchases, but also purchases of equities and commodities.

The Fed has created a Catch 22 for itself by tying the Fed Funds rate to “expected” inflation.  Its language was as follows.

In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal…

The Fed published a table and charts summarizing the economic projections and the target federal funds rate projections made by Federal Reserve Board members and Federal Reserve Bank presidents for the December 11-12 meeting of the Committee. I assume that the inflation contingency is based on these projections.  The FOMC and district presidents saw no likelihood of inflation reaching beyond 2%. Not now. Not ever. Let me say that again, just to make sure it’s not a typo. The Fed governors and bank presidents didn’t see inflation surpassing 2%, EVER.

Projections materials (PDF)

But what if, as I think highly likely, commodity prices surge as a result of this new round of money printing.  Normally, in the short run, commodity price rises do not filter into the inflation measures which the Fed watches.  Commodity price inflation could rage without pushing the PCE and core PCE to anywhere near the 2.5% threshold the Fed has set.

That has the potential to wreak havoc in the economy without raising employment levels at all. Manufacturers, middlemen and consumers would be squeezed by rising food and energy costs well before the Fed had any inkling of an increase in the tortoise like PCE measures. The cost squeeze would force consumers to cut back on spending, and manufactures, distributors and retailers to cut back on employment. Inflation would stop economic growth in its tracks, all the while the Fed is peering into its crystal balls a year or two ahead and seeing no inflation.

Then, as the economy ground to a halt, what would the Fed do? Stop QE because commodity inflation was crushing the economy? At that point that would run the risk of exacerbating the contraction. Print even more money, driving commodities up even faster? In truth, if commodities do go into bull mode, the Fed would seem to have no way out.

With the expansion of QE, the Fed has created a potential nightmare scenario, one that I think is all too likely.

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