The Federal Reserve's Drive to Inflation

The Federal Reserve will do everything it takes to hit its targets.

By + More

James Rickards is a hedge fund manager in New York City and the author of Currency Wars: The Making of the Next Global Crisis from Portfolio/Penguin. Follow him on Twitter: @JamesGRickards.

Recent economic news has been unqualifiedly good for President Obama. On January 27 the Commerce Department reported fourth quarter GDP growth at an annual rate of 2.8 percent, up sharply from a 1.8 percent rate in the third quarter. Last Friday, job creation was higher than expected and the unemployment rate dropped more than expected. Analysts disputed the news by pointing out that much of the improvement in GDP was due to nonsustainable inventory accumulation and the improvement in the unemployment rate was due to productive workers leaving the work force. This exodus of skilled workers bodes poorly for long-term growth prospects in America. But headlines count, and an 8.3 percent unemployment rate compared to 10 percent in October 2009 is exactly what the White House wanted. As they say on Wall Street, "the trend is your friend."

So it seemed odd to some that Fed Chairman Ben Bernanke, in a series of recent comments, made it clear that more monetary ease is on the way. The first two rounds of quantitative easing—buying bonds with freshly printed money—ran their course in 2009 and 2011. The market is eagerly awaiting the third round or QE3. Yet Bernanke did not refer specifically to quantitative easing. Further monetary ease is likely to have another name.

The two QE programs involved specific quantities of bond purchases over specific time periods. Markets quickly discounted the impact and began insisting the Fed do more. The next round of ease will involve a more open-ended approach where the Fed does not announce amounts or dates but rather announces targets for nominal GDP growth or unemployment. That way the Fed can do whatever it takes—printing new dollars by the trillions—until the targets are hit. The market will not be able to fully discount the amount of new money creation. They will discount the result instead including the possibility of much higher inflation—exactly what the Fed wants.

[See a collection of political cartoons on the economy.]

Still, the question is why will the Fed resort to more ease, probably this summer, if the economy is on the mend? The answer is that the Fed is not primarily concerned with conventional economic indicators. They may be moving in the right direction but will take far too long to achieve desired results. The Fed's real goals are to prop up asset values and cheapen the dollar. Those targets are just what the doctor ordered because the Fed can print all the dollars needed for as long as it wants to hit them.

The purpose of propping up asset values, such as stocks and housing prices, is to inspire confidence—the so-called "wealth effect"—and get people lending and spending again. The purpose of cheapening the dollar is to import inflation into the United States from abroad in the form of higher prices for imported goods such as iPhones, flat screen TVs, and clothing. Inflation is the key to the Fed's ultimate goal of negative real interest rates. When interest rates are 1 percent and inflation is 4 percent the real cost of borrowing is negative 3 percent. This means you can pay back a loan with dollars worth less than what you borrowed. It's like renting a car with a full tank of gas and returning it with the tank half empty and no charge for the gas.

This combination of a wealth effect through higher asset prices and negative real interest rates through inflation is the Fed's elixir to get people to lend and spend more, increase money velocity, and get the economy growing, at least in nominal terms. If it means your dollars are worth less because of inflation and devaluation then that's too bad. All the more reason to dump your dollars and buy stocks—or at least a new TV set.

[Learn about the many faces of Ben Bernanke]

The winners are those who see it coming and prepare for inflation. The losers are those who don't and suffer a diminution in their life savings, annuities, insurance policies, and retirement plans. The Fed has never cared about the everyday Americans who lose. It has devalued the dollar over 95 percent since 1913 in its efforts to benefit bankers at the expense of savers. The collapse of the tech bubble in 2000 and the housing bubble in 2007 do not deter the Fed. Inflation, a limp dollar, and asset bubbles are all in a day's work.

One of the most popular entertainers of the 1950s was a German-American bandleader named Lawrence Welk. He offered a sugary sound called Champagne Music. His television studio even had a hidden bubble machine that put out a stream of faux Champagne bubbles visible to viewers at home. Welk would set the tempo for his orchestra by lifting his baton and saying in a German accent, "A one, and a two...". Welk retired in 1982 yet his bubble machine lives on inside the boardroom of the Federal Reserve. One can picture Chairman Bernanke lifting his baton in front of the open market committee and saying, "A one, and a two…"

  • Read the U.S. News debate on whether the Fed has overstepped its mandate.
  • See a slide show of 6 ways to fix the housing market.
  • Rick Newman: One Key Sector That's Still Shedding Jobs