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This week's decision by the U.S. Federal Reserve to buy Treasuries in an effort to prop up borrowing is further proof that the economy is worse off than policymakers would have us believe. But more than that, the Fed's Treasury purchase plan is just one more reason for investors to anticipate inflation and take steps to protect their money from it.

In case you missed the news, here's what happened. The Federal Reserve on Tuesday announced that instead of allowing proceeds from maturing mortgage bonds to disappear from its balance sheet, the central bank would take the "modest" step of using them to invest in new Treasuries.

In plain English, that means that the Fed is reinvesting into U.S. Treasuries the money it would otherwise bank from maturing mortgages.

Its goal is very simple: to keep long term interest rates from rising. Many economists have pointed out that the consequences of the Fed's Treasury purchase plan will be minimal. And I agree. A mere $200 billion or so in such securities - out of the Fed's $2.3 trillion portfolio - mature yearly as homeowners pay off or retire their mortgages. So we're only talking about 8.69% of the total here.

But it's the Fed's read-between-the-lines implication that is really scary. By taking this step, U.S. Federal Reserve Chairman Ben Bernanke hopes to reassure global traders, and presumably the American public, that he is prepared to take even more drastic steps should the recovery grind to a halt. Chief among the Fed's options would be to buy more mortgage debt, which Bernanke believes would help keep down inflation.

Bear in mind, though, that at the height of this financial crisis, the Fed purchased a staggering $1.42 trillion in mortgage securities and some $300 billion in Treasuries to prop things up. And mortgage rates fell less than half a point. So much for that theory.

Something stinks here. Bernanke either knows something about the state of the recovery that he's not telling the public, or he's trying to telegraph something he believes is inevitable. Maybe it's both. But this isn't good news either way.

I have got to believe that it's finally dawning on Helicopter Ben that deficit spending and the Keynesian formula for consumer stimulation - upon which the Fed has based its entire recovery plan - don't work.

The housing market still stinks, mortgage rates are still falling despite being the lowest they've been in decades, and consumers have no money. Furthermore, the consumers that do have money are facing tighter credit standards and don't want the debt.

Frankly, I think that's actually a good thing because it represents a huge psychological change in our nation's reckless spending habits. However, from the Fed's point of view, it's a problem because its policies presuppose that government spending makes up the difference in consumer demand until demand can once again overpower the deficits induced in the effort.

But here's the real problem with the Fed's policy: By propping up the mortgage market, and by implication Treasuries, the Fed is only temporarily staving off inflation, while further selling out the dollar long-term.

The fact is that inflation is as inevitable as the sun rising tomorrow and there are now some $12.4 trillion reasons why. And so the problem isn't the mortgage market or even the manipulation of rates, but the eventual evisceration of the dollar. Regardless of government statistics that suggest inflation is under control, the reality is that inflation is already well underway to the tune of 10% or more in this country. You know that as well as I do by what happens with your wallet every day. The costs of education, medicine, and groceries are all up, up, up. Apparently, the government bean counters are the only ones who aren't feeling the squeeze.

The other thing to consider is that by propping up Treasuries in an effort to keep inflation low, the Federal Reserve is undermining any semblance of a strong dollar policy. Bernanke and Treasury Secretary Timothy Geithner may talk a good game, but the reality is that money flows to where it is treated best. And that doesn't bode well for the dollar in the long-term.

Once the dust starts to settle, international traders will move away from the greenback absent higher interest rates that compensate them for their investment. In fact, they've already begun doing just that. I know the dollar rose overnight following Tuesday's announcement but that's more in reaction to a short term flight to quality than a long term reflection or judgment of the dollar's staying power.

If it were, we would not have seen the dollar fall below 85 to the Japan Yen - a 15-year low - at the same time.

And don't forget about China. By propping up U.S. treasuries in an effort to keep interest rates from rising, the U.S. government may be trying to force the Chinese to revalue their Yuan more quickly than that government wants. This will go over like a lead balloon in Beijing, which holds nearly a $1 trillion of U.S. government paper in the form of short-term obligations.

So what we can do to profit from the situation?

There are three ways to capitalize here:

  1. Buy treasury indexed inflation securities or "TIPS" as they are commonly known. Because U.S. Treasuries remain one of the most liquid investments on the planet, it's very easy to participate in this trade. Inflation will get here - the only question is when. Now is the time to start hedging against it. My favorite choice is to begin averaging into a vehicle like the iShares Barclays TIPS Bond ETF (NYSE: TIP). The duration is a relatively short one -10 years, so most of the volatility that's going to plague long bondholders is avoided, but the potential return remains. I also like the 3.59% dividend yield, which compensates investors for the risks they take by holding this fund.
  2. Short the Japanese Yen: This trade is a bit more subtle. If the United Stats is once again openly diluting the dollar, we can reasonably expect the Japanese to react - though not immediately, because things take time in Japan...lots of time. Think about it this way: Japan's economy is largely export based and there is almost no domestic consumption growth. A more expensive yen versus other currencies makes Japanese exports less attractive, so the Japanese government is under intense pressure to reverse this trend by weakening the yen. My expectation is that this will happen by the end of 2010, when the pain threshold reaches a crescendo and companies like Toyota Motor Corp. (NYSE: TM) begin losing sales the way the German companies did years ago on the back of a super strong Deutsche marke. Spot FX or futures are your best bet here.
  3. Buy Chinese Yuan: I've often referred to buying Chinese yuan as the closest thing to a no-brainer on the planet. The only question, given the Fed's shenanigans, is whether or not you have the patience to sit it out. Revaluing the Chinese yuan is in China's best interest, but doing so is hardly in Washington's, especially now. I believe this will make for a potent combination when the timing is finally right and one of the easiest ways to participate is through the WisdomTree Dreyfus Chinese Yuan ETF (NYSE: CYB).

Of course you could also take the easy way out and simply short the U.S. stock market as a whole, but then you risk fighting a government that rightly or wrongly doesn't know when it's been beaten and refuses to give up.

Disclosure: None.

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Source: In Denial About the Dollar: Playing the Fed’s Treasury Purchase Plan