STAFF NEWS & ANALYSIS
Is KC Fed President Setting the Table for Volcker Round Two?
By - January 09, 2009

The Federal Reserve must have a plan to withdraw the hundreds of billions of dollars it is pumping into the economy or risk creating inflation during the recovery, Kansas City Federal Reserve President Thomas Hoenig said on Thursday. By the end of the second quarter, the Fed's balance sheet, now just above $2 trillion, could rise to $3 trillion, he said in remarks to an event organized by the Colorado State Bankers Association. "This is important as a stimulus and as a risk to the economy that we need to be aware of," he said. The Fed has cut interest rates aggressively and launched a range of lending facilities to boost the economy and stabilize financial markets thrown into chaos by the collapse of the housing balloon and surge mortgage defaults. The U.S. central bank lowered rates near zero from 5.25 percent in September 2007. Hoenig said the Fed's liquidity facilities and its recent purchases of securities are a powerful stimulus for the economy but are fraught with risks. – Reuters

Dominant Social Theme: These guys are always thinking ahead.

Free-Market Analysis: We have written about this before but it always gratifying to see one's speculation confirmed by someone directly in the know, as Thomas Hoenig surely is. Hoenig fears a paper money onslaught, courtesy of the upcoming American administration; and he rightly fears that an overpowering amount of money and credit, unmoored from any underlying asset, will give rise to a powerful wave of inflation. Of course, as we reminded readers recently, after inflation, inevitably there would come an effort at draining the economy of excess money. Hoenig, and others, are starting to sound the alarm about this as well.

It is easy to inflate an economy (though harder to re-inflate one); it is not easy to cool it back down, absent a crash. And a hyperinflation is even worse. Is it rude to speculate about Barack Obama's understanding of money? Does he fully understand the forces that he is playing with? Maybe so. There is probably a plan A, a plan B, a plan C, and many others as well. And there is always the sneaking suspicion that the end game regarding the dollar lies in the creation of an entirely new currency, either regional or international.

The sad thing, given what looms, is that the middle class is due for a severe case of whiplash – something else we have in fact mentioned in the past. The potential crack up – giving rise to the initial whiplash – began in 2008 with the deleveraging of American mortgages, a deleveraging that soon spread to other assets. The second whiplash may come as a result of wave on wave of dollars, euros, etc., that are aimed at re-inflating the economy. The third whiplash would be radical rate hikes designed to take the steam out of what could become a raging global inflation.

Crashes, powerful inflation and rapid rate hikes – that's the same recipe that ruined so many in the 1970s. It is not coincidence that tough-guy Paul Volcker, all six foot seven of him, has been brought in from the cold by the upcoming administration once more as a top-level financial troubleshooter. It was Volcker who engineered the 20 percent climb in rates in the late 1970s that finally helped shut down the inflation of that era. One shudders to think where rates might end up were Volcker to provide a reprise.

After Thoughts

Western economies are in a real fix. The money to be injected by the EU and the upcoming American administration will apparently go in part to bolster Internet technology and also to build green cars and encourage investing in green power, etc. This is speculative technology and we are not sure how it will provide long-lasting benefits. It will certainly provide inflation. Of course, if Hoenig (perhaps Volcker?) has his way, inflation will be dealt with sooner or later – and certainly painfully. In the meantime, if we are seeing a reprise of the 1970s, or even the 1930s, other economic arenas will also react as in the past. Hoenig didn't warn about the dangers of a rising gold price; not yet anyway. Just wait.

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