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"Stealth QE3" Comes to Fruition – Soaring Inflation is Next

U.S. Federal Reserve Chairman Ben Bernanke did what most everyone expected yesterday (Wednesday) at the culmination of the Federal Open Market Committee's (FOMC) two-day meeting – he left average Americans vulnerable to the pangs of higher prices and soaring inflation.

Indeed, as yet another FOMC meeting drew to a close without any significant policy changes, the central bank, as many predicted, kept interest rates at 0% to 0.25%, where they've been since December 2008.

And citing weaker than expected economic growth, the FOMC vowed to remain in an "accommodative stance" by retaining its huge $2.832 trillion portfolio of securities and loans.

The Fed will do this by using the money from maturing bonds and principal payments from its securities holdings to buy more bonds "according to a distribution that is nearly identical to that executed under the Treasury purchase program," according to the New York Fed statement – an extension of the quantitative easing (QE2) program in all but name.

Money Morning Chief Investment Strategist Keith Fitz-Gerald saw this "stealth mode" QE3 coming.

"Instead of printing more money, the Fed is likely to start reinvesting the proceeds of maturing debt," Fitz-Gerald said. "Ultimately, that won't reduce our government's bloated, toxic balance sheet. But it will change the makeup of that balance sheet – and not for the better."

By keeping interest rates at historic lows and continuing to reinvest in maturing debt, rather than retiring it, the U.S. Federal Reserve runs the risk of feeding an inflation rate that in recent months has risen to uncomfortable levels.

But that's something Bernanke has sought to acknowledge without taking responsibility.

"Inflation has moved up recently, but the [Fed] anticipates that inflation will subside… as the effects of past energy and other commodity price increases dissipate," the FOMC said in its statement.

When judging inflation, the Fed uses the core consumer price index (CPI), which excludes food and energy. In May the core CPI rose 1.5%, the most since January 2010 but below the Fed's informal target of 2%.

In his remarks yesterday, Bernanke said he favors the Fed setting an official inflation target, but the FOMC has set no timetable to do so.

Meanwhile, the full CPI increased 3.6% in May, the most since October 2008. Although the Fed likes the core CPI because it avoids volatility, many – including some within the Fed itself – believe the full CPI more accurately reflects the real-world experience of the U.S. consumer.

"One immediate benefit of dropping the emphasis on core inflation would be to reconnect the Fed with households and businesses who know price changes when they see them," James Bullard, president of the Fed Bank ofSt. Louis, said last month.

Fitz-Gerald was more blunt.

"Companies are, in fact, passing along costs as fast as they can," he observed in May. "McDonald's Corp. (NYSE: MCD), Nestle SA, and Wal-Mart Stores Inc. (NYSE: WMT) are just a few of the companies that have spoken out about the specific impact that higher component and ingredient costs have had on their earnings. Many have adjusted their guidance."

Making inflation even harder on average Americans is an unemployment rate of 9.1% and slumping wages. Average hourly earnings fell 1.6% in May.

Of course, using the core CPI number allows the Fed to sweep inflation rate concerns under the rug to pursue policies it believes will stimulate a stubbornly sluggish U.S. economy.

Yet those policies could ultimately prove ruinous to the U.S. economy.

"Be warned: There is every chance that the Fed will lose control, inflation will spiral – and not just to the ruinous levels we saw in the 1970s, but well beyond them, too," Money Morning Contributing Editor Martin Hutchinson said recently. "Inflation may become much more acute – reaching the excruciating/ruinous 20% to 50% level – rather than reaching and then holding steady at the uncomfortable-but-bearable 10% level.

"Even after that occurs, Bernanke will refuse to launch any sort of significant counterattack, or combat it," Hutchinson continued.

Ultimately, the Fed's buying binge could cause a runaway inflation rate that would create a crisis for the U.S. dollar.

"With the U.S. market straining under the burden of rising inflation and some ill-advised monetary and fiscal moves, the death of the dollar is looming as a worst-case — but still possible – scenario," Hutchinson said.

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  1. abdullah | June 23, 2011

    Dear Keith, Greetings for the past tow years we have been pounded a lot about global economy, fears of inflation, deflation, the death of the dollar, unemployment, weak housing data and so on as if every thing were shoved in a blender and given a full throttle, the only thing we are not hearing any solutions and as if the us government and fed has it, what really is driving investors traders bankers and every individual crazy is no one out there is really providing a solution to whats going on, there for its now the time to by pass governments and central banks and tap on individuals sentiments building up ideas and advices on how to efficiently and effectively work on an individual bases, maybe if we are able to have a kind of a global advice to individuals and work hand in hand to achieve wide spread knowledge on individuals to seek better alternatives, in my opinion the solution of a global economy recovery are no longer in the hands of governments and central banks, its in the hand of the small consumer, off course this comes with a price on the short term as consumer has the power to shift and jump boats, meaning if consumers will keep accepting buying higher priced products then things will keep going up, but if consumers are able to tighten and change their way of living and refrain buying well known brands as such domino effect this will build pressure i know this is hard but not impossible, i hope i may hear from you about this issue and your thoughts are highly appreciated

  2. Arun | June 23, 2011

    FED should sell the QE1 Assets on Discount to QE4 Receivers.
    This will trigger economic activity. And will Keep Fed's Balance sheet intact.

  3. Lee Adler | June 23, 2011

    I take the opposite viewpoint. I believe that the stand down from money printing in the short run is most likely deflationary, not inflationary.

    In the minutes of recent FOMC meetings and member speeches the Fed has repeatedly publicized that it will end QE at the end of June and reinvest the proceeds of maturing debt thereafter so that it would hold the size of its balance sheet steady. Rather than a stealth easing, this move will put the Primary Dealers on a starvation diet. They know it and they and other big players are front running that fact. Hence the big recent breaks in equities and commodities, including this morning.

    My position has been and continues to be that ending QE2, combined with the winding down of Federal stimulus spending will lead to a market and economic collapse this summer. This should be deflationary. The Fed, as is its wont, will then panic and institute QE3. It will almost certainly be in a different form than QE2, although, admittedly, they are running out of their sophomoric experiments.

    In the short run, holding the balance sheet stable cannot support further inflationary price increases. Those increases were driven by the Fed's pumping of cash into Primary Dealer trading accounts. When that stops, the fuel that fed the fire is withdrawn. The banks have locked up all of the reserves created by QE in deposit reserve accounts at the Fed. That money will stay locked up. The banks are too weak to deploy it. The have no place TO deploy it, even if they could. These reserves aren't going anywhere. My belief is that they can not and will not stoke inflation.

    I have real doubt that the next round of QE, coming in a panic response to crisis, will be able to stem the economic panic. The market players realize that we are beholden to a bunch of out of touch, delusional central bankers, who have no clue what impact their policy experiments will have, and who have no clue how to fix the incredible mess that they have made, a mess that cannot be undone. I believe that we are at the point of recognition.

    The big unsettled question in my mind is whether the final collapse that's coming will be deflationary or inflationary. It depends on what the central bankers' next panic move and the players' reaction will be, and the move after that and the reaction to that and so on. For that reason, I think the markets must be traded within a short time horizon and in that context I think that the next move over the course of this summer should be deflationary in nature.

    THEN comes QE3!

  4. bc | June 23, 2011

    This article highlights bitcoin's reason for being

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