Will the Fed Trigger Big Inflation?

What now after the Italian downgrade?

From Forbes:

Standard & Poor’s pulled another late move on Monday, downgrading Italy’s sovereign credit rating by one notch to A/A-1.  The credit rating agency cited weakening economic growth prospects as public and private borrowing costs rise, and a fragile political coalition failing to adequately respond to a challenging economic environment.

While the downgrade doesn’t come as a shock, as S&P had Italy under a negative outlook since May, it will rattle markets.  Europe’s sovereign debt woes have grappled nervous markets the last couple of weeks, with every word coming from Greece, Germany, or the ECB sparking massive moves on both sides of the Atlantic.

This has sent certain (risk-addled) European banks spiralling downward, leading the European Systemic Risk Board to warn policy-makers that the time may soon come to make a massive liquidity injection into European markets (i.e., throwing money at saving bad banks)

BNP Paribas:


In America, traders today were in a more bullish mood.

From Zero Hedge:

Shrugging off Italy’s rating downgrade (somewhat expected but continued negative outlook), funding stress in Europe (Libor levitating and Swiss/French banks divergent), cuts in global growth expectations (IMF and World Bank), concerns over systemic risk contagion (ESRB and World Bank), and escalating rhetoric in Sino-US trade wars, US equities have managed to reach up to Friday’s highs as rumors of AAPL being added to the Dow seemed enough for hapless traders.

More significant than excitement over Apple — and the main reason that markets today are levitating, in spite of all the turmoil — is the hope that Bernanke will throw more policy tools at the American economy.

Will he?

Although I have been specific about the idea that QE3 is definitely coming I don’t foresee QE3 being initiated this week. Why?

Firstly, because I think Joe Biden promised Wen Jiabao that America would hold off QE3 in the short-term to preserve the value of Chinese holdings.

Bernanke will probably initiate a program to roll the Fed’s holdings onto the long-end of the spectrum of bonds: as 2-year bonds in the Fed’s portfolio reach maturity, the Fed will replace those with 10-year bonds, to reduce net interest rates.

More significantly, I expect Bernanke to announce that the Federal Reserve will announce that it will no longer pay interest on excess reserves. Banks have accumulated massive excess reserves since the 2008 crisis, when the Fed determined to pay interest on reserves not lent — ostensibly to increase flexibility in the banking system in case of further collapse:

In theory, unleashing these excess reserves into the economy would get capital to productive ventures without infuriating bondholders and retirees any further with more quantitative easing. But in practice a surge in lending might do the precise opposite — unleashing a tidal wave of inflation, further diminishing the purchasing power of dollars.

The potential loans possible on these reserves could be up to $16 trillion. GDP is currently $14.99 trillion. Unless the GDP keeps pace with the money supply, these new loans would create the potential for substantial amounts of inflation.

Could this be the spark that triggers a runaway inflationary spiral? It could be. It’s not in the interest of either debtors, nor creditors — but that doesn’t remove the risk.

15 thoughts on “Will the Fed Trigger Big Inflation?

  1. since households don’t want to borrow any time soon, these excess reserves might flow quickly into commodities. then Obama will give a speech about nasty speculators again. I wonder where is the next ‘spring’ going to pop up.. India? Pakistan? Philippines? or perhaps another round of iSpot plundering accros UE..

    • Yes — they will not go to small business, but instead commodities desks.

      I wouldn’t be totally shocked if the next spring were an American one. India is culturally opposed to such a spring, so I doubt it will be there. Pakistan and Phillipines are strong candidates. Europe is a great candidate, too. You’re from Poland aren’t you, mantrid? A lot of young singleunemployed men there — women left for Germany, UK, etc. Polish spring? Any thoughts? Although I guess emigration to the UK is a pressure valve for Polish men, too.

      • Yes, I’m from Poland. one of journalists here described living in Poland like “swimming in a jelly pool: though as in water but every move costs you much more effort than in Western Countries”. Poles in general are used to this as most of them never had an opportunity to taste what “swimming in pure water” is like, so they won’t rebel. once EU funding (that is keeping quite a lot of bussiness alive) stops, unemployment will surge drastically. we’ll be back where we had been 15 years ago. I have a feeling people will partially understand it was a short dream all funded by wealthier states that got into trouble. anyway, they’ll keep low profile – waiver is too common, and people are divided in two competing political camps that hate each other.

        the young who had visited the West earlier will immidiatelly leave en masse to pick up jobs others don’t want. quite a lot of my friends live outside Poland already, and more now consider leaving too.

        I’ve just read today some 49 year guy set himself on fire in front of prime minister’s office (few days ago this happened in Greece too). but it’s not gonna be like the tunisan young seller who sparked the Arab Spring. he’ll turn into a campaign tool as we’re approaching elections. just like Smolensk accident did just before presidental campaign.

  2. The Fed already triggered “big inflation.” It’s been that way for decades now, but just slow enough for the sheeple not to notice so much. There’s too much debt in the system -too many claims without the productive capacity to service those claims. Deflation, therefore, will be the fundamental mover in the markets, but money printing will be the ultimate political response, because the banks will demand it. The Fed has been doing this since Greenspan -allowing the banks to become hedge funds and bailing out them out with debased dollars.

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