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By Michael Pento of Pento Portfolio Strategies

August 9 (King World News) - Central Planners Now Fighting A War That Will End In Tragedy

In the middle of July the stock market finally awoke from its QE-induced coma and realized that the Federal Reserve’s tapering, which has been going on for the last six months, was for real. Like a child who becomes accustomed to a parent who threatens punishment but never follows through, the market had been in denial to the Fed's withdrawal of monetary stimulus. Now, thankfully, the ending of Fed asset purchases will be the pin that pops this QE-inflated market and economy....

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But please do not confuse the end of QE with the Fed's actually fighting inflation and selling trillions of dollars worth in Treasuries and mortgage-backed securities (MBS), because that will never happen.

The Fed has increased its balance sheet by an unprecedented $3.5 trillion since 2008. The Fed accomplished this by purchasing Treasuries and MBS from banks in exchange for Fed credit. A credit from the Federal Reserve is a nuanced way of saying “new money."  This new money is transferred as a credit to the banks with the idea that the Fed can and will reverse this transaction at its discretion. 

As an army releases reserves, the Fed (with the help of private banks) has marched many of these new dollars into the economy to “save us” from deflation. Once the job is done, the Fed intends to call these dollars back and shrink its balance sheet back to pre-crisis levels.

This all sounds great in theory, but as we will soon see, the practical applications of shrinking the Fed’s massive balance sheet have become impossible without creating a monetary depression.

For the past few years the central bank’s credit inflation has been predominantly deployed in bonds, real estate, and equity assets. But  recently this new money has leaked into the government’s manipulated Consumer Price Index calculation. So our government no longer can promulgate the lie that inflation is some elusive goal that it cannot achieve. And the argument that stronger economic growth is around the corner in a context of low inflation has been fully debunked. 

That is why the market sold off last week. In a word, it is inflation. The Employment Cost Index (ECI) component in the GDP data put the Keynesians on “high wage inflation alert."

But most people will be blindsided by the temporary period of deflation that will result from the end of the Fed’s massive asset purchases, as the monetary spigot for the primary beneficiary of the Fed’s credit -- namely stocks and bonds -- gets turned off.

As with the housing market in the mid-2000s, we are about to relearn the lesson that many equity investors (especially those on margin) can afford to hold on to an asset only when prices are rising.

But on the other end of this cyclical period of deflation lies a period of inflation that will make the ‘70s seem like an era of hard money. This is because to fight inflation the Fed will have to bring home trillions of those “money troops” it sent into the economy. Calling the money back is going to be far more difficult than deploying it was.

When the Fed buys Treasury debt, most of the interest payments made go back into the government’s coffers. In fact, by law the Treasury has claim to all income derived from the Federal Reserve; less expenses. So the Treasury pays the Federal Reserve an interest payment and in return receives most of that payment back. This is a pretty good deal for the Treasury, considering the Fed’s profit is in the neighborhood of $91 billion a year. This means the Treasury not only didn’t have to find a real buyer for the newly issued debt but also did not have to worry about paying interest on that debt.

But it gets even better -- as the bonds mature, the Fed has been rolling over the principal. Therefore, it is as if the $2.4 trillion of newly issued Treasury bonds sold to the Fed since 2008 don’t even exist. The Treasury gets reimbursed on its interest payments and never even has to worry about what the cost would be for the private market to purchase that debt. To sweeten the pot, the Fed has pushed rates down to unprecedented lows, leading to relatively-modest debt service payments on all its record-breaking $17.6 trillion of outstanding debt.

However, if the Fed really wants to fight inflation, it will have to raise interest rates. Ending QE will provide only temporary relief from a weakening currency. To accomplish this in sustainable fashion the Fed will have to shrink its balance sheet to around the same level it was prior to the Great Recession.

How does the Fed shrink its balance sheet? When the Fed purchases a bond from a bank, it creates a credit that can be taken back at the Fed’s discretion. Taking the credits back is called a reverse repo -- the Fed sells the assets back to the banking system and takes back the cash.

But the Fed cannot just conduct reverse repos in the trillions of dollars without putting extreme pressure on the market for private short-term loans. So the government is not only going to have to sell the more than $2 trillion in bonds into the market; it will have to start paying real interest on that debt as well. And the private market will have to finance all the new annual deficits, which will no longer have the luxury of a trillion-dollar-plus annual QE program from our central bank.

The net effect of all this would be surging interest rates and economic collapse. This is why I do not expect the Fed’s balance sheet to significantly contract for many years if at all. And I predict inflation will become a huge problem, especially after the central bank launches another massive QE program in 2015 to re-inflate falling stock prices.

Our government is in a horrific trap because of the record amount of debt it has issued and has allowed the central bank to monetize. This is why every time the Fed tries to fight asset bubbles and bring inflation under control, it will result in a monetary depression. This is also why nearly every central bank has decided that the only real long-term objective is to fight deflation and ensure that inflation will prevail.

To learn more about Michael Pento’s financial management services CLICK HERE.

© 2014 by King World News®. All Rights Reserved. This material may not be published, broadcast, rewritten, or redistributed.  However, linking directly to the blog page is permitted and encouraged.

UPDATE - The extraordinary audio interview with Michael Belkin is available now, to listen CLICK HERE. 

IMPORTANT - KWN has many more interviews being released today.

The audio interviews with James Dines, Michael Belkin, Dr. Paul Craig Roberts, Andrew Maguire, Art Cashin, Michael Pento, Gerald Celente, MEP Nigel Farage, David Stockman, William Kaye, John Hathaway and Marc Faber are available now. Other recent KWN interviews include Jim Grant and Felix Zulauf -- to listen CLICK HERE.

Eric King

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