Game changer?

While the nation was otherwise occupied with AIG bonuses (and SMI staffers were occupied with completing the April issue), the Fed announced last week that it will "pump an extra $1 trillion into the financial system by purchasing Treasury bonds and mortgage securities" - a plan "that amounts to creating vast new sums of money out of thin air," according to the New York Times.

The action makes the Fed a buyer of long-term government bonds rather than the short-term debt that it typically buys and sells to help control the money supply....The idea was to encourage more economic activity by lowering interest rates, including those on home loans, and to help the financial system as it struggles under the crushing weight of bad loans and poor investments....

[T]he Fed was taking risks that could dilute the value of the dollar and set the stage for future inflation....

In effect, the central bank has been lending money to a wider and wider array of borrowers, and it has financed that lending by using its authority to create new money at will.

In his weekly commentary, John Hussman, manager of the Hussman funds, expresses grave misgivings about the Fed action (as well as about economic policies emanating from the White House and Congress):

In effect, the Fed intends to monetize the Treasury debt in an amount that exceeds the entire pre-2008 monetary base of the United States.Apparently, the Fed believes that absorbing part of the massively expanding government debt and maybe lowering long-term rates by a fraction of a percentage point will increase the capacity and incentive of the markets to purchase risky and toxic debt....

There is no doubt that the Fed also intends for the extra trillion in base money to end up as bank reserves. But think about what this move implies in equilibrium. The largest purchasers of U.S. Treasury bonds at present are foreign central banks. So what the Fed is really doing is printing enough money to crater the exchange value of the U.S. dollar, while leaving foreigners with a trillion dollars of savings that they would otherwise have invested in Treasury bonds, which they will now use, not to buy our lousy, toxic assets, but to acquire our productive assets, and at a steep discount thanks to the currency depreciation....

Ultimately, funding the bailout of lousy assets comes at the cost of debasing our currency and selling our good assets to foreigners.

Make no mistake - we are selling off our future and the future of our children to prevent the bondholders of U.S. financial corporations from taking losses. We are using public funds to protect the bondholders of some of the most mismanaged companies in the history of capitalism, instead of allowing them to take losses that should have been their own.....

The bondholders of poorly run financial companies should lose because they deserve to lose. The American public does not.

Given current policy, Mr. Hussman thinks inflation is likely.

The reason we're not seeing inflation here and now is that despite a near doubling in the monetary base, we've seen a buildup in goods inventories combined with a surge in safe-haven demand for government liabilities....This will not persist indefinitely.... [I]nflationary pressures [will begin] as soon as safe haven demand for Treasuries eases back even moderately.

This story from today's New York Times suggests that such demand may be weakening already.

UPDATE: Speaking Thursday at the College of Charleston (S.C.), Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, acknowledged that heading off inflation won't be easy.

"Whether [current policy] has an inflationary impact or not depends on our skill at the Federal Reserve in withdrawing the stimulus in a timely way when the economy begins to recover. That is a very delicate, very hard policy," he said.

_____________________________________________________________

Joseph Slife is a contributing author and editor for SMI. Visit www.soundmindinvesting.com to learn more.