The Fed's Clear Goal Is to Increase Inflation

Bill Fleckenstein MSN Money November 1, 2010

As markets struggle to figure out the Fed's next move, they're missing an important point: The central bank will succeed at raising prices, in spades.

I think stock bulls may be getting a little overly optimistic thinking about the next round of quantitative easing (aka QE2) from the Federal Reserve and the possibility of gridlock in Washington after the election, as they are factoring in all of the potential positives and none of the negatives.

After all, there is no way interest rates are going to stay where they are indefinitely, and, once they start higher, they are liable to rise dramatically.

The really intriguing question is, will QE2 lead to a sell-off in any or all markets?

QE2: Help for the economy?

Obviously, I don't know exactly what the Fed is going to do (besides create lots of inflation), but we could see a program as large as $1 trillion to $1.5 trillion (or something like $100 billion a month for the foreseeable future). A possible Fed game plan: Underpromise and overdeliver However, that opinion is at odds with an Oct. 27 Wall Street Journal article by Fed correspondent (and unofficial spokesman, according to many) Jon Hilsenrath, along with co-writer Jonathan Cheng, headlined "Fed gears up for stimulus." They throw cold water on the prospect of another massive dose of monetary action and write that the Fed is likely to "unveil a program of Treasury bond purchases worth a few hundred billion dollars over several months."

That could be less than the $500 billion or so that New York Fed President Bill Dudley had talked about a little more than a week ago, and, perhaps more importantly, smaller than what stock bulls have been counting on.Msn.Video.createWidget('PlayerAd1Container', 'PlayerAd', 300, 213, {"configCsid": "MSNmoney", "configName": "player-money-articles-16x9", "player.vcq": "videoByUuids.aspx?uuids=3bae0997-4e7e-4c29-85ca-4006dc299d9a,b2749d8f-715a-4fcd-b4e5-9e816cdc34f4,c816841d-d5d3-43b7-9750-ca03440b0dfb,d3846022-4066-414c-911b-f76b91b49249,687d785f-3a97-4977-abab-41371a901b9e,5dc4af9e-04d3-4fe3-99cd-8e3fe61ecce5,8b71adcb-b595-4b92-ae5b-10f07b4243b1,f9c7bee7-4186-4486-958c-6593a9d815b3", "player.fr": "iv2_en-us_money_article_16x9-investing-contrarianchronicles"}, 'PlayerAd1');Msn.Video.createWidget('Gallery4Container', 'Gallery', 304, 150, {"configCsid": "MSNmoney", "configName": "gallery-money-articles", "gallery.linkbackLocation": "bottom_left", "gallery.numColsGrid": "3", "gallery.categoryRequests": "videoByUuids.aspx?uuids=3bae0997-4e7e-4c29-85ca-4006dc299d9a,b2749d8f-715a-4fcd-b4e5-9e816cdc34f4,c816841d-d5d3-43b7-9750-ca03440b0dfb,d3846022-4066-414c-911b-f76b91b49249,687d785f-3a97-4977-abab-41371a901b9e,5dc4af9e-04d3-4fe3-99cd-8e3fe61ecce5,8b71adcb-b595-4b92-ae5b-10f07b4243b1,f9c7bee7-4186-4486-958c-6593a9d815b3;videoByTag.aspx%3Ftag%3Dmoney_dispatch%26ns%3DMSNmoney_Gallery%26mk%3Dus%26vs%3D1;videoByTag.aspx%3Ftag%3Dbest%2520of%2520money%26ns%3DMSNmoney_Gallery%26mk%3Dus%26vs%3D1"}, 'Gallery4');As noted, how markets respond is a function of what has been discounted, or worked into, stock prices in anticipation. If the Fed does more than is now expected, stocks and bonds presumably will rally (before they are sold off). That would likely be the last hurrah for those who expect deflation and their favorite momentum-trading vehicle: bonds.

Fortunately, in a few days we will know what the Fed plans to do.

So rather than spend more time musing about the Federal Reserve's next move, I'll focus on the big picture: namely, that the Fed has been telling all of us for the longest time exactly what it intends to do, and that is to create inflation.

As longtime readers know, I expect the Fed will succeed in this -- beyond its wildest dreams. Such stuffed shirts as dreams are made of I have never been a member of the deflation camp. The Fed is essentially the engine of inflation even when it is not working overtime to create rising prices, as it is currently. To me, it is shocking that people don't believe the Fed will achieve its mission of creating more inflation and even more amazing that they believe deflation is occurring or about to occur.

(For more on why the Fed is more worried about deflation than inflation, read "Not your grandfather's deflation.")

However, having said that, lacking faith in a determined Fed does have important (though erroneous) precedents. Few thought then-Fed Chairman Paul Volcker could conquer inflation when, on Oct. 6, 1979 (a Saturday night), after a Fed meeting, he announced that the central bank would raise the discount rate a full percentage point, to 12% -- a level most investors these days have never experienced.

Volcker stated, "We consider that this action will effectively reinforce actions taken earlier to deal with the inflationary environment."

As we all know now, he was determined to break the back of inflation, but no markets believed it at the time -- certainly the gold market didn't.

From a price of approximately $385 an ounce the Friday before the rate hike, gold screamed higher until peaking at $850 on Jan. 1, 1980. In other words, the gold market -- a barometer of the prevailing sentiment regarding inflation at that time -- more than doubled in about three months. That rise in price shows how little conviction buyers in that market had that Volcker would be successful.

Regardless of the current whining from the Fed about the risks of deflation and about inflation being unacceptably low, it is far, far harder to tame inflation than it is to create it (both in reality and politically). Thus, when adjusted for the "difficulty factor" of achieving the stated desired results, the current gap between the market's view and the Fed's intentions may be the biggest disconnect of all time. Rockets' red glare, bonds bursting in air Meanwhile, the belief in deflation, the Fed's injections of cash into the financial system by buying bonds and, most importantly, today's ridiculously low yields have combined to create the conditions for what could be the final rally in that market for a long while (assuming it hasn't already transpired).

The next stage for Treasurys will be a long and brutal bear market, which will have negative ramifications for the stock market as well.

By discussing all this, I don't mean to imply that bonds must collapse immediately. After all, a 30-year trend doesn't turn on a dime. But those who are expecting material gains from bonds (which essentially represent "return-free risk") in the coming years are liable to be wildly disappointed -- not to mention poorer.

At the time of publication, Bill Fleckenstein owned gold.More from MSN Money

Not your grandfather's deflationInflation-spooked investors run for coverWhy you (probably) need more gold10 ways to survive a zombie economyIs the US stumbling into a currency war?

Rate this Article Click on one of the stars below to rate this article from 1 (lowest) to 5 (highest). LowThank you for rating.UGR('ratCntrl')High var avgRating=0;avgRating=8.771428; if(avgRating!=0){avgRating=avgRating/2;avgRating=Math.round(avgRating*100)/100;var sDisplayText="Average rating: " + avgRating + " from ";var usersCount=140;sDisplayText = sDisplayText + usersCount;if (usersCount==1)sDisplayText=sDisplayText + " user";else sDisplayText=sDisplayText + " users";avgRatingElem=document.getElementById("averageRating");avgRatingElem.innerText=sDisplayText;} View all top-rated articlesE-mail us your comments on this article Discuss in a message board MSN Money InsightNew Investor CenterMarket DispatchesJubak's JournalTop Stocks blogCompany FocusContrarian ChroniclesSmart Spending blogFast AnswersDecision CentersStart InvestingMutual FundsFind Hot StocksSimple StrategiesPower ToolsInvesting for IncomeReal Estate InvestingRecent Contrarian Chronicles ArticlesNot your grandfather's deflation 10/15/2010Why you (probably) need more gold 10/08/2010Is the US stumbling into a currency war? 10/01/2010More . . .Contrarian ChroniclesAbout Contrarian ChroniclesLearn the Contrarian Chronicles lingoSubscribe to Market Rap on Fleckenstein CapitalFund data provided by Morningstar, Inc. © 2009. All rights reserved.StockScouter data provided by Gradient Analytics, Inc.Quotes supplied by Interactive Data.MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.Msn.Video.createWidget('Gallery8Container', 'Gallery', 500, 230, {"configCsid": "MSNmoney", "configName": "gallery-money-article-site-wide"}, 'Gallery8'); 2CommentsNewestOldestBestWorstControversialLynn X6 hours ago

The next stage for Treasuries will be a long and brutal bear market, which will have negative ramifications for the stock market as well.

After all, there is no way interest rates are going to stay where they are indefinitely, and, once they start higher, they are liable to rise dramatically.

This is going to break a lot of older people who were dedicated savers all their lives. The only chance we have now is with stocks in the right sectors and there is plenty of risk there too.

0 0ReportSpamWorking MondayFri 10:24 PM

6-7% Fed Rate within 2 years and decrease in tax rates should get things rolling after 'election day'........continue to be strategic in equity purchases, dump bonds, and enjoy making profits again! Don't forget to VOTE!

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