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A key tenet to my outlook is the expectation of low interest rates through 2012's ARM reset, but commodity inflation could force Fed action toward the contrary.

The consumer will just have to bear the burden of high food and energy costs, but the Fed won't react unless an increase in bank lending stifles Core CPI, threatening hyperinflation. Consensus will recognize the next six months as a stagflationary environment. As we near the June expiry of QE2, the U.S. Dollar Index (DXY) will have softly approached 74 (and likely 71) thanks to a stronger EUR, but it will rally from there, along with JPY. At this point, the Fed must keep its foot on the gas -- using its portfolio interest and maturity proceeds -- to provide monetary support throughout fiscal consolidation, then apply fiercely countercyclical force when the economic upswing persists.

In the wake of Wednesday's entry about my secular economic outlook, I thought I'd discuss some near-term challenges to my timeline. In the end, I'm on the lookout for confirmation of a null hypothesis. In other words, once I've formulated an opinion, I look for evidence of the contrary to help me identify the risk or the breakdown of my convictions. Commodity inflation could dramatically change the trajectory of my outlook. Since it's all the rage with oil back over $100 and an agricultural boom (food shortage) ein force, I'll start there.

Many have criticized the Fed for focusing on Core, as opposed to Headline, CPI in its measure of inflation. Commodity inflation is undoubtedly hurting the consumer. Remember, however, that deflation and inflation are the Scylla and Charybdis of this crisis. Further, with ZIRP and QE already in force, deflation is the scariest monster.

I opine that inflation -- to a point -- might just be another penance for the consumer to bear in retribution for his overleverage. (It's compounded by the fact that the government can consciously dole out such penance, and it hits the bottom 30% of earners & retirees the hardest, while aiding banks. That's an unsavory travesty.)

This turns ugly if it persists for too long or if it evolves into hyperinflation, which would require an earnest rally in Core CPI (ex-food & energy). A spike in bank lending is the most probable catalyst of such hyperinflation. The Fed has tools to combat such a spike, at least more confidently than they can combat deflation at this point: It's tested reverse repos; it can raise the interest rate on excess and required reserve balances; and so on.

Am I too casual in my expectation that the Fed can absorb excess liquidity? No. The Fed engineered this recovery when it souped-up banks with the risk-free carry trade, and it can perpetuate this mechanism or reverse it with the same market intervention. However, as we approach that point where the consumer collapses beneath food and energy inflation, how can the Fed control a runaway in these specific inputs without pushing the core inputs into deflation?

Well, the DXY is resting on a trendline as it approaches a double bottom at 76, the next stops are 74 with a second support at 71:

[Click all to enlarge]

DXY daily- 1st support @ 74, 2nd support @ 71. Resting on trendline.

The yen (USDJPY) is also at a similar bottom, which ends at a spread double bottom at $80, which you'll have to zoom out to 1995 to see:

USDJPY daily- 1st support at 81.12, 2nd at 80.
USDJPY monthly- spread double bottom at 80.
These could be the most important charts in my arsenal right now, because they seem to hold the key to life-after-QE2: the USD has room to slip in the months leading up to QE2's expiration in June. The yen doesn't look like it's willing to give any more ground, so in neat coordination with my EURUSD bullish-catapult thesis, a strengthening euro might drive DXY just that smidge lower. Upon finding support (my target is 71), DXY should rally through June and the summer.
My guess is that the Fed won't have to intervene in markets to limit the inflation-driven increase to commodity inputs. A certain portion of food inflation is coming from shortages -- although the ag boom is a secular investment theme of mine. A certain portion of energy inflation is coming from social turmoil in MENA states -- although oil prices remained stubbornly high throughout 2009-10 (without any contribution from economic demand). Attributable to these cyclical socioeconomic and geopolitical factors, the lack of a additionally significant catalyst should limit the size and (more importantly) the length of the upside in ag and oil, ushering the Fed to the QE2 expiration amid taxpayers bemoaning a stagflationary environment.
That all assumes that the powers-that-be react rationally to the challenges before them (i.e. without panic and with perspective). Weary of the double-dip, Ben Bernanke is a god-fearing student of the Great Depression, and therefore dovish. Yet some Fed governors are dissenting in hawkish opposition.
I'm a vocal critic of our government's disinflationary approach to economics since the Volker Fed, but since we chose "stimulus" yet again with QE2, it's my opinion that we must follow through now, then apply intensely countercyclical force in the upswing of economic vitality. I agree with Bernanke that early stimulus withdrawal would be more devastating than the alternative. (Perhaps I lack adequate perspective, since the inflation that exists doesn't relatively trounce my disposable income.)
This monetary support can be provided rather effortlessly as interest and maturities hit the Fed portfolio from investments in Treasuries/MBS for programs like QE1 & QE2.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Source: The Fed's Fight With Inflation and Deflation