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Here's a brief recap of how the Fed has backed itself into a dead corner and ruined the world along the way:

  1. QE1 + QE Lite + QE2 = massive injection of liquidity in USD. Whereas QE1 had been accepted by most of the world, if grudgingly, as a necessary evil, QE2 has been subject to much wider questioning and criticism.
  2. The massive liquidity in USD quickly leaked out of the U.S.'s borders, via its reserve status, to emerging markets in search of return.

  3. In the face of universal demand destruction in the developed world, EM did not have nearly enough productivity growth to absorb the massive hot money organically. So inflation rose rapidly. This is in stark contrast of the deflationary developed world.

  4. EM installed a series of capital control policies, in conspiracy-theory worthy synchronicity, to fend off the hot money originating from the Fed.

  5. The hot money from the Fed got pushed back into developed world, mostly ended up chasing equities and commodities. Some have used corporate earnings to explain the equities and supply-demand for commodities. Such efforts are akin to attributing all forms of cancer to smoking. It may be convenient and conforming to popular sound bites, and it maybe a factor in some cases. But the rest can only be supported with stupidity.

  6. The commodities bubble has caused much pain in the marginal economies in the world, including ongoing social unrest and civil wars. Such geopolitical events have fed back to the commodities bubble, with no sign of containment in sight.

  7. While the U.S. has arguably the most capacity to absorb the pain caused by the commodities bubble, it is by no means insulated. High oil and agricultural commodities prices have affected and will continue to affect U.S. consumers and corporate earnings directly. Industrial metal and other commodities prices will affect at least indirectly. Either corporate profit margins will be squeezed, or consumers will be squeezed, or more likely both.

What's the Fed to do when the inflation chicken comes home to roost? The first choice is to QE3 or not to QE3? The deadline for that is fast approaching. But even this first baby step in normalizing monetary policy will prove to be very ugly and painful either way.

To QE3:

If Fed follows through with QE3 or otherwise keeps expanding its balance sheet, it would no doubt add even more fire under the commodities and equities bubbles, at least for awhile. But the dollar would be slaughtered. The worldwide hunt for an alternative would take on added urgency. And at some point, which could come very soon since oil is already above $100, the commodities inflation forced by the Fed will come back and kill the U.S. economy just when it's at the most vulnerable state. Social unrest may spread to much of Asia and even Europe as the commodities inflation forced by the Fed peels off more and more layers of the socioeconomic onion.

As for the U.S., more and more people would go hungry unless the central government keeps expanding various welfare programs. And if the government does this, look forward to a dollar devaluation feedback loop and some very strange looking yield curves. In this scenario, the only hope is Hoenig and your guns.

Not to QE3, or otherwise to shrink the Fed's balance sheet:

Treasuries would tumble across the curve. All credit costs would rise, except the very short term. This would exacerbate the pain for corporations and consumers already suffering from Fed-manufactured inflation. The recovery has zero staying power without the continued supply of Fed Viagra and would promptly go limp. The housing market would at least go back to its historically reasonable levels, which is about 10-40% lower than today depending on the region. More likely it would overshoot to the downside and stay there until the economy finds an organic growth path.

Equities would either crash or go through a painful long slide, or both. The dollar may rise in the short term, but its longer term outlook would be very foggy as several major, contradictory factors would be at play for a long time.

In both scenarios, precious metals will do well, at least on relative basis compared to other assets (equities, bonds, other commodities). In the QE3+hyperinflation case, gold is the inflation hedge. In the deflation case, gold is one of the only channels for all the excess money to go to -- it will take years to drain the excess money even under the most hawkish assumptions.

In retrospect, the Fed had the last chance towards the end of last year to ease out of the liquidity deluge at a relatively small price. Instead, they did QE2. History will judge such a grave mistake with equal graveness.

As a long-term gold bull, I really should not complain so much about the Fed. They have proven me too paranoid and timid in my gold bullishness over and over. They have shown me the power of faith, the faith in their ability to screw up beyond reason. Recent surge in gold/silver have been driven by geopolitical events. If/when these events change direction, there may be a pullback. Consider it a gift.

Disclosure: I am long GLD, SLV, PHYS, DBA.

Source: Fed Action: Bad for World Economy, Good for Gold