The mandate for the Federal Reserve is [i] Stability of prices [ii] high employment. Obviously they are failing on both counts, but their thinking process is important. With the monetary policy that they have at their disposal, how, does Bernanke go about fulfilling the Feds mandate, with the additional pressures from the Treasury and Congress to fund their fiscal policies?

*Needed to fund US national debt
*Needs to maximise Bank profits

To fund the US debt, money/credit creation is the only way. If Congress will not cut expenditures to match revenues, the debt at this point is so large that the interest payments being offered are simply not attractive to selling the debt to the market. If the interest rates were to rise, the repayments become prohibitive, and bankruptcy ensues. Thus we have the low rates at the Fed Funds Rate for the foreseeable future.

The flip-side of low interest rates are a weak dollar. Mercantilism has always advocated exports over imports. The more goods/services you export the more [gold] money that you receive in return. Without exploring all the fallacies, Mercantilism is a failed economic strategy. Add to that fact that many economies are trying to effect the same strategy, and you have the current state of affairs.

A low exchange rate also has the effect of raising nominal stock prices and nominal commodity prices to offset the otherwise lost value stolen via the inflation. In this aspect, the QE has succeeded: the nominal prices in all the financial markets are far higher than they would have been without the inflation.

The weak dollar however in relation to other currencies, the Yen, Euro and Yuan creates problems [perceived] for these economies: the Euro needs to be weaker vis-a-vis the dollar to address their ever increasing debt pressures in Greece, Ireland, Portugal and Spain. The German banks, who have purchased gobs of Euro denominated debt, will fail if the aforementioned default, taking Germany into the abyss with them. Thus the Euro requires the low ground, of course, so do the Dollar, Yen and Yuan.

So what’s Bernanke to do? The recent Fed meeting that concluded this week was the culmination of the game that Bernanke has been playing with QE2. Take a look at the chart that summarises the quagmire that Bernanke finds himself.

QE2 effectively was the way in which, surreptitiously, the Federal Reserve funded the government. The top 5 debt holders: Federal Reserve is now the largest holder of US debt, with almost $1.4 Trillion. The other high holders being China and Japan. Should either one stop purchasing, or even start selling, to diversify away from the US dollar, then the effect on interest rates will be enormous, they will rise, and rise significantly.

If they do, the interest rate burden will increase dramatically. Already the interest cost consumes 15% of revenues, which don’t even come close to covering the expenditures: further debt increases interest payments, consumes greater % of revenues, requires more…it only has one outcome.

Only a Central Bank can afford to own debt that yields below the inflation rate. No private investors will purchase debt that creates for them a guaranteed loss. So unless the interest rate rises above the inflation rate, no-one will purchase Treasury debt [this was the purpose of QE2] PIMCO and Bill Gross have sold all Treasury debt, and not only that, they have sold it Short. This is so major that I’m surprised not more has been made of it. Without a QE3, QE4, etc, interest rates will rise.

Look at the unfunded liabilities: $113.5 Trillion. Where is that money coming from? Unless productivity goes through the roof, the US is in deep trouble. The market thinks so. Look at the 10yr Credit Default Swaps rate, the market is starting to price in a default. Medicare and Medicaid together constitute 2/3 of these liabilities. They simply need to be cancelled. [I’ll look at the implications later.]

Essentially the government via inflation has never stopped defaulting. Default on debt is government policy, always has been. Nothing looks set to change.

To date, most of the inflation has been centered in the financial markets. For businesses this means rising production costs as the cost of raw materials rise. This creates a significant margin compression which cannot be passed forward to the consumer, not at least while there is competition, either direct, or indirect via substitution. Only as competition from high cost producers forces them out of business will we see the production costs be passed forward into consumer prices.

We have already seen it within two industries: energy and food. Both have raised significantly their consumer prices. For the consumer, there is no substitution possible with food, and only minimal with energy. Food prices are rising via stealth tactics, smaller serving sizes at the same or slightly higher prices. Inflation from the producer prices is set to enter consumer prices very soon.

So what is Bernanke’s strategy?

Being an academic, being a Keynesian, he will resort to a strategy determined possibly via a Game Theory strategy. Game Theory posits a strategy by where you don’t lose. It’s not really designed to create a winning strategy. This will appeal to Bernanke, who caught in the politics, will not want to execute the politically unpalatable, but maintain the status quo as long as possible.

Thus a policy of managing perceptions and expectations: this is the jawboning strategy that has been employed by Greenspan before him. So we know what he can’t have: a rising dollar and rising interest rates, although that is exactly what the US needs. Thus he must move towards the policy of eliminating the QE programs, with incremental moves to minimise the rise in interest rates and a stronger dollar. This is gradualism, which, essentially do as little as possible, preferably nothing at all.

So the message from the Federal Reserve?

[i] Do not commit to anything with regard to QE2 other than to say, it will end in June. Provide no further guidance as to extensions, new QE3 policy. Zip. Nada.

[ii] Leave an escape route open. By not committing to anything other than reaffirming the conclusion of QE2 in June, Bernanke is not ruling out a QE3 or QE4, but neither is he committing to one. He hopes, one supposes, that the markets will not decide to take a firm direction based on this rather unsatisfactory state of affairs.

If QE3 was a certainty, then markets [stocks, commodities] would continue their rise, the dollar would continue its plunge and interest rates would fluctuate around Fed purchases. If QE2 was the final QE program, then markets would react in the opposite manner, and another 2008 would be upon the markets.

So bearing in mind that ideally, Bernanke wants and needs a QE3, but cannot politically announce one currently, should the markets fall or plunge after QE2 ends, this will provide enough of a smokescreen to implement a QE3. Should markets not fall, but continue to rise, Bernanke is off the QE3 hook for a time anyway, and look at raising the Fed Funds Rate from 0.025% to say 1% over a period of time and 0.025% increments.

Will Bernanke’s strategy succeed? I don’t think so, but we’ll have to wait and see. My prediction: expect more [a lot more] volatility.