The Fed’s Big Bet

After the Federal Reserve announced its latest quantitative easing scheme, there’s been a lot of speculation about the short and long term ramifications, both good and bad.

In the near term, the move makes long-term debt more affordable for businesses and consumers, which theoretically can boost spending, leading to job creation as businesses hire to meet the growing demand for their goods and services.
It’s fine if that process takes a while, as there is no time limit on QE 3, so the low rate borrowing and easy cash will keep flowing until the economy improves.

In the longer term, however, this vast expansion of the money supply from QE bond buying binges at minimum threatens to cut the value of currency and anything denominated in it.
In other words, the big concern about QE 3 is rising inflation.

We must remember that the Fed needs to keep a lid on inflation but also maximize employment, which may be counteracting.
The worst case result from QE 3 is that in the future we’ll have unstoppable hyperinflation that could be as fatal to the economy as the current threats declining growth and mass insolvency from excessive debt.

Meanwhile, low growth and weak employment are keeping inflation at or below an acceptable 2% in the US, despite rising commodity prices.
Lowering unemployment from an unacceptably high 8% is the priority for now, hence unlimited money printing.

What happens if inflation becomes a threat, and growth remains stagnant?
How will the Fed navigate the conflicting demands of its mandate?

Fed Chairman Bernanke hasn’t defined the Fed‘s maximum acceptable inflation, but the Federal Reserve Bank of Chicago President, Charles Evans, has advocated continued easing until either unemployment falls below 7% or inflation rises above 3% and stays there.

So it appears that until it’s 3% or more, inflation is not even on the Fed‘s radar.
Unfortunately, history has shown repeatedly that once an inflation wildfire breaks out, it can spread quickly and is often incredibly difficult to extinguish.

Therefore, this is the Fed‘s big bet: if this latest expansion in money supply brings inflation over 3%, they in fact will be able to control and reduce it quickly enough to avoid material damage.
Some experts believe that “The great inflation” of 1965-1980 was caused by the very same thing as QE 3, policy makers expanding money supply too much, too fast, in order to fight unemployment.

Put simply, if the Fed has miscalculated and politicians don’t take the threat of inflation seriously, it may be too late before they realize the errors of their ways.

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