Can the Fed Prevent Inflation Surge?

Donald Kohn, Fed Vice-Chairman, today in Nashville, Tennessee said that the Fed will not allow its "unorthodox" policies to trigger a surge in inflation. Really, that is very powerful statement by the Vice-Chairman. He also said that the Fed must remain flexible:

"That flexibility could entail doing more to ease credit if the economy proves resistant to the monetary and fiscal stimulus now in train,"

How exactly is the Fed going to prevent a surge in inflation?

"The key to preventing inflation will be reversing the programs, reducing reserves, and raising interest rates in a timely fashion," Kohn said.

Easily said then done. The magnitude of the positions/purchases that the Fed has made indicates that it will not be that easy to reverse. Am I being to pessimistic?

Our current problem is not one liquidity. It is matter of insolvency and nothing has been done to address that. The Fed and Treasury can do all they want with our money to ease credit but it won't do any good. Treasury reported last week that banks are not lending and that is after trillions of dollars pumped into the financial conglomerates. Am I missing something? I am not an economist but I did stay at a well-known motel chain once.

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that's a good question

what is the historical content of reversing the money printing machine, supplies, debt to curb inflation and once the cat is out of the bag, such what is the ride down and it's implications?

One problem I see right now is never in history has the U.S. owed so much in debt to other nations, especially one nation, China, controlling so much of it...

so that's another analysis question, how does that come into play in this "winding down" to avoid inflation?

"Over dinner at a prominent

"Over dinner at a prominent newspaper the other evening, journalists mused over the threat of inflation. They were not the first to do so. Many people, some of them influential, are warning of the threat of inflation.

"Prominent amongs these are commentators and journalists, even economists, that do not understand the nature of bank money. They invariably confuse it with the tangible stuff that appears as notes (printed) and coins (minted). As a result, they believe that what the Bank of England is doing is printing billions of these notes. Naturally such a misconception leads them to assume that we are threatened now by the sight of Mervyn King pushing a wheelbarrow stashed with billions of pound notes around the City of London - followed by the spectre of inflation.

"If ever you meet up with such a scaremonger, here’s a counter point to put to them.

"Money and debt is being destroyed. Some call it de-leveraging. Others call it debt write-offs. Or debt cancellation. Bankruptcies invariably involve debt destruction - because bankrupts do not pay back their debts, so they get written off. The point is that money/debt is being destroyed in vast uncountable quantities.

"Sudden Debt has helpfully provided some examples of truly remarkable debt destruction. The Ford Motor Company is planning to ‘eliminate’ about $10.4 billion of debt. In other words, they are trying to remove the debt from their books. “Ford will pay 30 cents to 55 cents on each dollar of debt, depending on the type of note. Ford’s debt is trading publicly at about 20 cents on the dollar” according to the New York Times of the 4th March, 2009.

"In other words, 45 - 70 cents of every single dollar of debt owed by Ford is to be destroyed, or ‘eliminated’. $10.4 billion of the stuff. Indeed Ford is being generous. Creditors would lose 80 cents of every dollar if they dealt directly with the market in Ford debt.

"Similarly in Spain, the bank Santander is selling its shares in Compania Espanola de Petroleos SA - a large oil company, for less than half the closing price of CEPSA shares. The reason for this? Santander desperately needs the cash, and so the bank is destroying half the value of the shares it owns in CEPSA. (Bloomberg, 25 Feb. 2009)

"The destruction of money/debt is best described as deflation. Deflation of the vast credit bubble that was blown up over the last three decades.

"What the Bank of England and other central banks are concerned to do, is to replace the debt being destroyed, with new money. The trouble is, that the amount of debt being destroyed is so vast, that to replace it would require even vaster injections of new money. Right now, the central banks and Finance Treasuries are just not keeping up with the amount of debt being destroyed. Indeed they do not even know how to count it, or assess the amounts outstanding.

"As long as they don’t, for so long will we not have even the remotest threat of inflation. Instead we will be faced by a far worse fate: a sustained and destructive debt-deflationary spiral."
--Ann Pettifor

I wouldn't define deflation that way.

But the real risk is that the Fed mis-times pulling back on liquidity and tightening balance sheet in a timely and sufficient matter. It would not be the first time Fed mis-timed its change in policy and positions but the magnitude of the position will make a mistake very huge.

I heard or read it this way (maybe even on EP): imagine holding a basketball underwater but when you release that ball it shoots up with great force. I think what all those people Pettifor refers to are implicitly saying that they don't have any confidence that the Fed will time this thing right.

Traders are expecting it

Like I posted the other day, Eurodollar prices are dropping across the calendar, indicating ever higher rates. Eventually somethings got to give.

"Conditions today are

"Conditions today are essentially the same as during the great depression. I talked about this in Humpty Dumpty On Inflation. When I wrote that piece, I listed 15 conditions one would expect to see in deflation and the score was a perfect 15-15. I recently added a 16th: bank failures. Click on link to see the conditions table.

"Those who stick to a monetary definition of inflation pointing at M2, M3, MZM, or base money supply, as well as definitions that involve prices are selecting a definition of inflation that makes absolutely no practical sense.

"It is the destruction of credit, coupled with the fact that what the Fed is printing is not even being lent that matters, not some Humpty-Dumptyish academic definition that has no real world application!

"I have long been arguing that we are in deflation based on the following definitions: Inflation is a net expansion of money and credit. Deflation is a net contraction of money and credit. In both definitions, credit needs to be marked to market."
--Mike Shedlock

China is anticipating inflation.

China bought $5.6 billion in bills and sold $964 million in U.S. notes and bonds in February, according to Treasury data released April 15. It was first time since November that China purchased more bills than longer-maturity debt.


Looks like they want to stay liquid as possible and try limit interest rate risk.

Is the risk of interest

Is the risk of interest rates rising (due to downgraded bond quality) the same as inflationary risk? (Given the extent of excess capacity in our manufacturing sector (and not just ours, by the way) isn't inflationary risk far less than the risk of deflation?