In life, there is frequently little, or even NO, relationship between the OSTENSIBLE problem and the REAL problem. This, we believe, is the case with regard to the FED's dilemma. Before we address the issue of what constitutes the TRUE dilemma which may confront the FED shortly, we want to make one point: At this time the FED does not confront any dilemma, OSTENSIBLE OR REAL. However, the FED may confront an extremely difficult -- and possibly insoluble dilemma -- as it proceeds with an aggressive program of liquidity creation. To return to the first point, OSTENSIBLE versus REAL. A multitude of voices contends that the FED confronts a dilemma currently. This dilemma is the supposed Hobson's choice betwen fighting a deflationary downturn at the cost of aggravating an energizing inflation surge OR allowing the recessionary and deflationary forces to have their way. Some of those who argue in favor of the latter course of inaction suggest that such a choice is an artificial one, as these alleged recessionary forces are not that strong, and that deflation is a threat only in the sick imaginations of the febrile. Others in this camp tout the allegedly therapeutic consequences of allowing substantial liquidation to occur without interfering, as this will supposedly clear away the underbrush of evils spawned by excessive debt, spending, and speculation, and will lay the groundwork for a far sounder and more noble edifice. Those in the liquidationist camp exude more than a faint odor of stern Calvinist morality. Others suggest an angered -- and relatively impoverished -- traditional upper class incensed at the vast riches of the nouveaux riche who have waxed fat on speculative profits, new technologies, and skill in stock market maneuvers. Finally, there is the distinct odor of letting the peasantry receive its comeuppance and re-learn its divinely ordained place in the natural order of things. This group has as its hero, Richard II, who exploited peasant anger to strengthen his hold on the monarchy and then turned viciously on those who brought him to power: "Villeins ye are, and villeins ye shall remain," he famously declared. Today's liquidiationists -- those spiritual heirs to Andrew Mellon and Herbert Hoover -- in fact posit a NON-EXISTENT relationship between aggressive monetary and fiscal policy action and bailout efforts to prevent a potential deflationary disease with feeding the flames of the future INFLATION DEMON. In this, too, they follow in the footsteps of Mellon, Hoover, and the Federal Reserve of the 1929-1932 period, who were fortified in their paralysis and incompetence by a fixation on a non-existent inflation threat, and thereby enabled the blossoming of the most acute deflationary depression in the history of the Republic. What then is the FED'S REAL DILEMMA? This dilemma -- which is NOT currently extant, but which may be summoned from the "vasty deep" of the Witch of Endor -- inheres in the potential crystallization of the buried fears of inflation which the liquidationists are laboring assiduously to call forth. These fears -- night terrors, if you would -- derive from the memory, actual or figurative, of the great inflation of the 1970s. This was, indeed, a terrible experience, but nowhere near as terrible as a classic depression. Moreover, in the current deflationary environment, inflation is as likely to emerge from an aggressivelyaccommodationist monetary policy and a banking system bailout as you, dear reader, are likely to sprout wings and fly to the moon. The dilemma is NOT that inflation will ramp up, but that INFLATION TERRORS will, finally, frighten the bond market. If bond investors become alarmed, they WILL sell their bonds. The concomitant rise in market rates will strangle a damaged, struggling economy, and will intensify the powerful depressive and deflationary forces currently at work. FEAR of such a bond market response -- which would substantially NULLIFY FED resuscitatory efforts -- create a potential dilemma of grave proportions for the FED. If such inflation fears materialize in the only place where they really count -- in the Treasury market -- then the FED will be damned if it does (supply ample liquidity) as the market would nullify these efforts -- and damned if it doesn't -- without the necessary expansion of liquidity, a deflationary contraction of significant dimensions seems to us difficult to avoid. We, for our part, DO NOT expect this true dilemma to materialize: bond investors are likely to continue voting with their money in accordance with their read on the economy, on the trend of prices, and of the ACTUAL DIMENSIONS of the inflation-adjusted expansion of the money supply the FED may achieve. Having said all of this, we must also acknowledge that the bond market does indeed draw a red line beyond which the FED DARE NOT CROSS. The FED, with a few more rate cuts and some other liquidity enahancement measures, may come dangerously close to this line. Here it will have to stop, regardless of the turmoil in the economy, and regardless of the pain such a halt would portend. Bond investors, after the gruesome experience of the 1970s, simply will not tolerate any movement which even remotely suggests the possibility of a printing press inflation. Like the ten tribunes in the Roman Republic, who stood outside the Senate chamber with the power to forbid any enactment by the Senate, the bond market holds an un-overrridable: |
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