Will the Fed be able to restrain inflationary pressures?

In two recent SMI cover stories (May and August), Austin explained why current fiscal and monetary policy could lead to a surge, perhaps even a strong surge, in inflation.

While Federal Reserve Chairman Ben Bernanke is busy offering repeated assurances (here, for example) that when the time is right the Fed will act to restrain inflationary pressures, Wall Street Journal columnist George Melloan is unconvinced. He argues that it will be quite difficult for the Fed to change course - for technical reasons and political ones.

Federal Reserve Chairman Ben Bernanke [has] assured [Americans] that he has the tools to prevent the huge reserves he's pumped into the banks from generating an inflation that would abort an economic recovery.

But does the Fed have the guts to use those tools? Will it risk censure from Congress and the Obama administration if it tightens money at the crucial juncture when inflationary omens accompany a reviving economy?...

[But q]uite apart from the question of the Fed's will, there is another large issue. Mr. Bernanke's assurances to the contrary, there can be doubts about whether his tools are really adequate to deal with the powerful inflationary pressures the politicians are in the midst of creating in the form of a mountainous and rising federal deficit....

The Fed has been financing a significant part of the government's profligacy, and it is riding a runaway horse....

The Treasury (and Congress) has been depending on the Fed's massive buying of Treasury bonds to keep the government's financing costs within reasonable bounds - as weakening international demand puts downward pressure on bond prices and upward pressure on the interest rate the Treasury must pay....

The Fed has more than doubled the size of its balance sheet in the last year to over $2 trillion. As of July 30, it held $695 billion in Treasurys, up $216 billion from a year earlier. In addition, it has added nearly half a trillion of mortgage-backed securities it purchased to keep Fannie Mae and Freddie Mac, now wards of the government, afloat....

The standard way for the Fed to soak up liquidity...is to sell Treasurys to the banks. That would draw down bank reserves and reduce their inflationary potential....

But the Fed buys Treasurys primarily by creating new money, or in other words by inflating the money supply. Will it have the nerve or even the capacity to "sterilize" inflation by reselling the bonds to soak up bank liquidity?

This all gets a bit technical, but the point is that choking inflation, especially if it has started to pick up steam, is much more difficult than stoking inflation. And poll-driven politicians are likely to be exceedingly unhappy with what will be required, especially if the pain reaches its peak during an election year.
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Joseph Slife is a contributing author and editor for SMI. Visit www.soundmindinvesting.com to learn more.