The Fed

Monetary Transmission

There is a debate as to whether QE is inflationary. The below chart demonstrates how the process works and will bring to light that QE is inflationary. If not for QE, which is effectively the next step once interest rates hit the zero bound, then the system will collapse and we will have a depression.

How The Fed Will Act

The Fed actions have been consistent over the years. Here are observations I made over the past 20 years:

  1. The monetary system is fiat based. The historical limitations that shackled the Fed under the gold standard no longer exist in the short term. The short term is relative to history, not one’s lifetime.

  2. The fiat system is unstable. The system requires continuous expansion of the monetary base and credit or deflation will set in.

  3. The Fed will always bail out the financial system. If not, they will be replaced as their mandate is maximum employment and stable prices. If the financial system is not functioning (i.e. overnight lending rates spike), then the unemployment rate will rise and deflation will set in. The Fed will act to prevent any financial instability.

  4. The Fed will tighten once inflation increases to high levels. This will produce a recession and disinflation. However, this will only be temporary. They will restart the process of lowering interest rates and expanding the balance sheet once it becomes obvious the economy is entering a recession

  5. If deflation sets in, the entire system will collapse and depression will take place. So the Fed must expand the monetary base despite the high debt to GDP ratio.

  6. Of late, it is very difficult for the Fed to put the economy in recession due to political pressures, a larger segment of the population aware of the Fed’s actions, and the unstable financial and economic system the Fed has helped create.

Conclusion

As you can see, there is one common theme in all these observations. The Fed cannot allow deflation and therefore cannot allow the financial system or economy to have any major disruptions. So they will always expand the monetary base and therefore credit, interrupted by short term tightening regimes.

These above observations will not go on in perpetuity. See the End Game for how this all ends.