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Federal Reserve Continuing the March Down the Primrose Path

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Federal Reserve Chairman Ben Bernanke and his army of economists have now had four months to observe the lay of the economic land since winding down the Fed's massive $1.2 trillion in mortgage backed securities purchases.

Based on Chairman Bernanke's recent comments before Congress it would appear that they don't like what they see. 

The Mother of All Bullets

During difficult economic periods pressure is put on the Fed to "do something!" to fix the problem, perhaps in particular by a Congress facing reelection and historic low popularity

During the Fed Chairman's recent semi-annual testimony before Congress, Senator Jim Bunning asked "Are you out of bullets?" Bernanke's response: "Well, I don't think so."  

"Bullets?" What metaphorically are Jim and Ben referring to? 

To answer that question we have the luxury of being able to refer back to a Ben Bernanke speech in 2002 titled Deflation: Making Sure "It" Doesn't Happen Here (which I've written about previously). 

The economic problem du jour just happens to be deflation, and in his speech Bernanke outlines detailed steps the Fed could take to combat it. 

Bernanke's most oft-quoted line from the speech is: "the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost."

In short, Dr. Bernanke's prescription for deflation is for the Fed to print a ton of money. 

How much? Given that the nearly $2 trillion printed since the inception of the 2008 financial crisis hasn't created significant inflation concerns, estimates of an additional $5 trillion may not be outlandish.

QE 2.0: No Longer a Question of If, But When?

On Thursday St. Louis Fed President Jim Bullard (who is also a voting member of the Federal Open Market Committee) wrote that the U.S. is at risk of Japanese-style deflation and that the Fed should combat it by engaging in "quantitative easing" (aka printing money) by purchasing U.S. Treasuries.

One interpretation of "inflation hawk" Bullard's comments is that the Fed is beginning to lay the groundwork for "QE 2.0", which is the label that has become attached to any new massive Fed money printing campaign.

So when precisely would QE 2.0 begin?

It's unclear how big a timing x-factor the November U.S. congressional midterm elections are for a major Fed move. While Bernanke is a Republican, he was reappointed by President Obama. I suspect that, barring another major crisis, Bernanke would prefer for QE 2.0 to be perceived as apolitical as possible and, as a consequence, may hesitate to start printing more money until after midterms.

Whether the Fed engages in a phased implementation or one Big Bang QE 2.0 announcement may be driven by the speed of events. While the Fed may prefer to trickle QE 2.0 out over an extended period ala the Bank of England's QE program and as Bullard suggests, a sudden and rapid deterioration in confidence may force the Fed to go the "shock and awe" route.

Meanwhile In Government Debt La-La Land...

In contemplating a new $5 trillion QE 2.0 program, a reasonable person might ask "so, if the Fed keeps printing money and buying things like U.S. Treasuries, what is government debt and the U.S. dollar really worth?"

The prospect of QE 2.0 may be driving U.S. Treasuries to rally even further into nose bleed territory as the market contemplates the Fed gobbling up even more government debt. And if the Fed doesn't activate QE 2.0 then deflation (or disinflation) could continue to make U.S. Treasuries attractive to investors. So on the surface U.S. Treasuries may hold the appearance of a win-win trade.

However, QE 2.0 at the levels we're describing would be a massive monetary and economic experiment. As we're in unchartered territory it's impossible to know for certain precisely how events would unfold.

Author, professor and trader Nassim Taleb is calling government debt "the next Black Swan." In a recent interview he even went so far as to call government debt "a pure Ponzi scheme".

There are several ETF options available for those looking to hedge or play a possible decline in U.S. Treasuries. And if the prospect of massive money printing has you concerned about the future of paper money, then you may want to consider precious metals such as gold.

Disclosure: Long Gold and Silver