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We’re not there yet, but we are close. The FOMC is likely facing inflation problems at the same time that it faces problems in the financial system. Goods price inflation versus Asset price deflation. There is a term for this, but it is easy to be marginalized if one uses the S-word too readily. So I won’t.

On the other hand, I am almost done with James Grant’s Money of the Mind. Several themes come to mind here regarding government policy in the late 1920s and early 30s, most notable that the government tried to force credit onto an economy that had too much credit already. First they tried to get the private sector to do their bidding. When the private sector would not cooperate to the desired degree, the government entered the lending business itself. This probably prolonged the Depression by not allowing bad debts to get liquidated on a timely basis.

But, if I use the D-word with respect to today, it is even worse than using the S-word as far as credibility goes. So I won’t, except for historical reference purposes.

The thing is, though, the FOMC is running out of options. Pretty soon, it will have to decide which pain is greater: goods price inflation, or asset deflation. Given the current political demographics, I believe they will choose goods price inflation, while saying the exact opposite, or doing the intelligent equivalent of a mumble.

Final note: current FOMC policies are a bit of a joke. The temporary nature of them (see TAF), plus the reduction in T-bill holdings, particularly during year-end, when liquidity is needed for the “holidays” of some, is unusual to say the least. If the Fed is serious about reflation of assets, it needs to do a permanent injection of liquidity, and stop messing around with these temporary half-measures.

PS — All that said, if I were Fed Chairman, I would presently aim monetary policy to a yield curve that had a 1% spread between 2-years and 10-years, and then I would leave it there. There would be screaming for a year, but the excesses would get bled out of the system. After that succeeded, I would narrow the spread to 0.5%. The economy would remain stable for a long time.

Source: Tough Times for FOMC