Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

" Shock And Awe"------ What Is The Fed Telling Us?

By now you've all heard about QE3, the unprecedented action by the Federal Reserve last Thursday. To get some perspective on this action, we need to review the mandates of the Fed. Under federal law, those mandates are to maintain sustainable, non-inflationary, long-term growth; and to maintain full employment to the extent possible.

The action taken by the Fed on Thursday September 13th was an open-ended purchase of $40 billion a month for as long as it takes to get unemployment levels back down to an acceptable level. The Fed also stated its intent to keep interest rates near zero % until mid-2015. Less than a year ago they said the same thing, but limited the duration until mid-2014.

At $40 billion a month . . . that is $480 billion a year, all of it new, freshly printed, money. That's a lot --- if that money were sent directly into the economy by way of a tax rebate, it would add 3% growth to our Gross Domestic Product per year. The irony is that it's almost the exact amount of money needed to offset the January 2013 "fiscal cliff" we have all been increasingly concerned about.

And the Fed is not simply injecting $480 billion into the economy; they are purchasing mortgage-backed securities in the open market. In other words, they are targeting mortgage rates specifically, in hopes they can drive interest rates down. And who is selling these mortgage-backed securities to the Fed? Pension funds, mutual funds, foreign countries, banks, and various other institutional funds.

How will the sellers deploy the capital from these sales? It could go to fund stock purchases, other bonds, or simply sit around as cash, which by the way is earning zero%. Is that what the Fed intended? Probably not . . . the stock market seemed to like it, and strangely enough we saw the bond market selloff. The ten-year Treasury is now trading around 1.75% --- up from 1.68% a few days ago. So the sellers' capital appears to be going into stock purchases and other inflation-protected securities.

This brings me to our topic today: what is the Fed telling us? Due to the unprecedented size of QE3, and especially to the open-ended nature of its purchases, which could go on for many years, we should probably conclude that it is not inflation that is concerning the Fed; in fact, it may be the contrary --- deflation. Japan has suffered with deflation for the better part of 15 years. Yes --- I said "suffered." So if the Fed's recent action says nothing else, it says "No Inflation in Sight." It also suggests that maybe things are worse than we initially thought.

We all know that consumption drives the economy, so let me just ask you --- are you borrowing any money at today's extremely low rates? You aren't, are you? Under today's conditions, you would normally be borrowing all you could. But you're not. In a previous article, we talked about how lending standards have tightened significantly, contributing to the problem. We also pointed out that demographics here in the US are not conducive to consumption, unless demographics are offset by immigration --- and that observation annoyed some of you.

But we also talked about how a weak dollar would support exports from the US. Well, guess what the dollar has done since the Federal Reserve's recent surprise? You got it --- it has tumbled.

The big debate today is between Keynesian economists and those advocating more traditional theories. The Keynesian theorists believe the Government should be dumping all the liquidity into this economy it possibly can, both through monetary and fiscal policy: Spend, Spend, Spend. Their fear is a liquidity trap, and that fear is clearly supported if there are in fact deflationary tendencies. Let's review Keynes' definition of a liquidity trap: Karen Murdasi, in her article "Keynes and the Liquidity Trap" explains this best:

(1) The government (or the central bank) can try to reduce the 'price' of money by lowering interest rates. The laws of supply and demand say that low demand reduces the price of goods to a level where people want to buy them. In the case of money that would mean reducing the cost of borrowing, i.e. interest rates. The trouble is that in a recession, people may be so unwilling to borrow and invest that it is impossible to reduce the price far enough. Once interest is at zero, there's nowhere else to go.

(2) The government (or bank) could increase the money supply - they could literally (or electronically) print more money. The idea is that this money will work its way around the economy, allowing people to spend and invest more, and increasing employment. The trouble is that when times are bad people want to hold on to their money. They don't want to invest it in stocks which might fail, or spend money on goods and services when they fear it will leave them short later. They feel safer holding on to money in 'liquid' form (NASDAQ:CASH) which means that all the new money released is hoarded by nervous banks and savers, and does nothing for the wider economy. This is what Keynes identified as "the liquidity trap".

In other words, Keynes is describing what we might call the frontier "badlands" of economics . . . the lawless border area where the "normal" rules of supply and demand lose their force, where human fears outweigh all other considerations, and where it's every consumer for himself.

Theoretically, as prices fall at some point, the consumer will eventually buy. A good example is the PC industry. Because of technology and production improvement, average prices fell from around $3000 to $500 in a relatively short time, to a point where it's now sometimes cheaper to buy a new one than to fix the old one. And this has happened without the negative demographics we touched upon earlier.

Is this what the Fed is telling us? Certainly the Keynesian Theory sounds very relevant to some of the things we have been considering. After all, absent food and energy inflation, we would already have a deflationary economy. Without the weather-driven rise in food and commodity prices, and without the ever-simmering crises in the Middle East, would the picture look different to us? Maybe so.

Perhaps the Fed knows something we don't know . . . because under normal conditions, this unprecedented injection of capital into the system screams hyper-inflation. Surely the Fed would not sacrifice one mandate to promote the other . . . or would they?

Move over, Dos Equis Man. Ben Bernanke is now The Most Interesting Man in the World.


Mike Chandler

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.