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Rules of the Road

   Contrary to popular belief the Fed will not be able to continue purchasing assets to hold down rates indefinitely.  Inflation is beginning to filter down through the economy and this will constrain possible courses of action if they wish to retain their ability to control the yield curve.  Their course is being charted for them by two unbreakable rules:

1)  The Fed must avoid any action which would make the public suspicious that the dollars in their hand are not worth what they say.

And what is essentially the specific case that can cause #1:

2)  The FRB must not increase the amount of new money at such a rate and with such speed that the public gets the conviction that the rise in prices will continue endlessly at an accelerated pace.  This will cause an episode of hyperinflation.

Although I disagree with everything Bernanke has done - and everything written by him that I've read - I do believe that he is in fact a smart fellow.  He recognizes these two truths, which is why he has begun his extremely awkward press conferences.  He knows that even the appearance of transparency is sometimes enough to dispel some suspicion and mistrust and it will allow him slightly more freedom in which to operate.

I also feel that he recognizes #2 which means that he cannot create any type of QE3 or anything that can be viewed as a QE3.  Maintaining his balance sheet at the same level by reinvesting is not the same thing as directly increasing the money supply.  After the QE2 increase works its way through the economy the lack of further price increases will effectively put a chill on the hyperinflationary case.

With the hyperinflationary method a non-starter the only recourse for Mr. Bernanke is to let the current "stimulus" run its course.  This eventually means higher rates across the curve which is negative for most macro indicators as well as stocks, bonds, and commodities - especially money substitutes like gold and silver.  This could show up in equity markets as lower margins due to cost pressures as well as the higher discount rate making the capitalized value of a given set of cash flows significantly smaller.  In fact, the only thing this is good for is the USD which could strengthen vs. all major currencies.

Thoughts?