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Fed’s Exit Doors Close: Inflationary Spiral Ahead

Economics / Inflation Apr 14, 2011 - 02:37 AM GMT

By: Dr_Jeff_Lewis

Economics

The pressure for the Federal Reserve to raise interest rates to put a damper on inflation is growing strong.  This week, Reuters reported that Bill Gross’s PIMCO Total Return Fund, the largest mutual fund in the world, had reduced its US Treasury holdings to zero, and then followed the sale with a short-position, signaling to the market that holding US debt is not only risky, but also an entry into an asset class that provides a negative return when adjusted for inflation.


Future rate hikes from the Federal Reserve would seem obvious, if they weren’t nearly impossible.

The other side of the Fed’s rate hikes

At the height of the financial crisis, the Federal Reserve took steps that put the institution in uncharted territory; not only would the Fed push rates to record lows, but it initiated a program that would pay banks for their reserves held at the Fed.  This decision was made with the understanding that it could keep rates low for considerable periods of time, as long as it was willing to pay banks to do nothing with their money.

Unfortunately for the Federal Reserve, banks have a profit-motive, and the current negligible return of .25% isn’t going to keep bank reserves high for very long.  With inflation fears growing, banks with assets at the Fed are going to deploy these excess reserves, which will only begin the inflation tidal wave.

The Federal Reserve can do two things: it can allow rates to rise and begin to pay banks higher rates of return for their more than $1 trillion in excess returns, or it can keep on the worn path of inflationary decisions.  Each decision is only temporary.  While the Fed can hike rates, it will have to start paying banks a greater return on their excess reserves.  As these excess reserves grow, then there will be no possible exit strategy—the Fed will have to create more inflation to prevent inflation.

Concerning similarities to the Great Depression

Any student of economics remembers the reason of the Great Depression:  the inexperienced Federal Reserve allowed for huge increases in the monetary base before allowing credit to contract by as much as one-third, which sent the United States into immediate depression. 

This time, the Federal Reserve isn’t going to cut back on the inflationary pressure.  Instead, it’s brining in a new arsenal of monetary policy mechanisms that have never once been tested.  There is no historical reference point for the possible outcomes that result from paying banks to hold excess reserves, and we can’t possibly know how the Federal Reserve can reduce the supply of money if it has to create more money to do so.

Bank reserves at the Fed are soon to enter the open market.  Each and every dollar used to buy US Treasuries and mortgage-backed securities at the height of the crisis will flee.  The Fed, still holding assets worth less than what it paid for them, cannot exit fully its policy decisions without selling its assets.  And it cannot sell its assets without pushing rates higher.  Higher rates, however, are sure to require that the Fed create even more money out of thin air to keep reserves from the open market.

The next year is going to be one of turmoil, inflation, and rising concerns about how the new policy measures created to solve the world’s financial crisis are bringing about a new financial crisis.  The only safe place to be is that which is backed by real, tangible value: precious metals.

By Dr. Jeff Lewis

    Dr. Jeffrey Lewis, in addition to running a busy medical practice, is the editor of Silver-Coin-Investor.com and Hard-Money-Newsletter-Review.com

    Copyright © 2011 Dr. Jeff Lewis- All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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