The Fed announced this week that it will buy up to $1.250,000 million in treasuries, mortgage backed agency debt (Freddie and Fannie) and other papers. This a week after the Chinese Prime Minister voiced concerns about the value of the $2,000+ million in U.S. assets China holds.

China is especially concerned about agency debt since the U.S. took Freddie and Fannie into receivership but did not formally guarantee their debt. China is also concerned about the value of long term treasuries which would sink if interest rates in the U.S. would increase.

While the last point may be of no immediate concern, with the all the money the U.S. will have to print now eventually the long term interest will rise sharply and treasuries will thereby lose in value.

For some time China is selling agency debt and long term treasuries and instead buying short term treasuries. But the large amounts China has of those unwanted assets can not be sold without some big buyer. So the Fed stepped in and will now buy what China wants to sell.

Of course there are additional reasons for the Fed to buy 'assets' with freshly printed dollars. The U.S. will run $1,000,000+ million deficits per year for the foreseeable future. It has to issue treasuries for that. China may buy a few of those but it seems it would rather like to buy other assets like raw materials or debt and companies denominated in other currencies. The Fed will therefore have to buy the treasuries the U.S. government issues and will have to print additional dollars to finance the purchase.

This is not without costs. In theory the Fed should sell those treasuries when the economy revives and thereby drain the additional liquidity it now provides. But it will likely miss the right point in time out for fear to repeat a mistake FDR made back in the 1930s. In 1937 out of concern for too high deficits FDR pulled back from some of his depression programs just as the economy started to revive. Without the government support it promptly fell back into a recession. So the Fed will miss the right point and will start late to sell its treasury holdings and to drain the market of dollar notes. It will thereby incur high losses and be unable to drain all the money it currently pushes out.

As Kurgman explains:

[T]here will come a time when the Fed wants to withdraw that extra $1 trillion of money it created. It will presumably do this by selling the bonds it bought back to the private sector.

But here’s the rub: if and when the economy recovers, it’s likely that long-term interest rates will rise, especially if the Fed’s current policy is successful in bringing them down. Suppose that the Fed has bought a bunch of 10-year bonds at 2.5% interest, and that by the time the Fed wants to shrink the money supply again the interest rate has risen to 5 or 6 percent, where it was before the crisis. Then the price of those bonds will have dropped significantly.

And this also means that selling the bonds at market prices won’t be enough to withdraw all the money now being created.

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My back of the envelope calculation looks like this: if the Fed buys $1 trillion of 10-year bonds at 2.5%, and has to sell those bonds in an environment where the market demands a yield to maturity of more than 5%, it will take around a $200 billion loss.

If the Fed now buys $1,000,000 million of Treasuries it will only be able to sell those for $800,000 million when interest rates go back to normal territory. Thereby 20c of any dollar the Fed prints now will stay in the system and will have real inflationary effects.

The government then could print more IOU's, i.e. treasuries, hand them to the Fed for nil so the Fed could sell those and could thereby withdraw the excess money supply. But those additional treasuries would of course add to the debt of the U.S. taxpayer. I therefore find it unlikely that any future U.S. administration will want to add to its debt just to cure inflation.

So however one thinks through this, the effect of the current process of the Fed buying up treasuries will eventually be inflationary. It is not the total $1,000,000 million fresh dollar the Fed is now pushing out by buying treasuries that will have inflationary effects. But maybe 20-40% of that as the Fed will eventually drain the rest. But do not think for a moment that the Fed will stop after buying up the now announce $1,250,000 million in debt issues. This 'quantitative easing' will continue as otherwise there will not be enough buyers for all the deficits and debt the administration is running up.

It usually takes some years for a serious inflation to take a hold. But when it does it is damned hard to erase it. The next year or two or three may look deflationary. But raw materials are already running up again and I for one believe the will continue to do so – at least in US$ terms.World population and demand still grows and raw materials are limited.

This whole process described above is to a certain degree unavoidable. But a lot of the debt the U.S. is taking on now and that is the basic reason for the mechanics described above is taken on to rescue a failed banking system. AIG has so far received $173,000 million, but it's financial arm that wrote all the lunatic CDS contracts still has $1,600,000 million of nominal obligations. There is no plausible reasons for the U.S. taxpayer to back those up. But the current administration does it and the taxpayer will have to bear the consequences.

In the end this could softly devalue the U.S. dollar until some current account balance is found between U.S. exports and imports.  But bthat is benign and unlikely case. More likely is that these trends will overshot and ignite a strong inflation in the U.S. with raw material prices, denominated in US$, going through the roof.

The models used above to describe the dynamics are very simplified. In reality there are multiple and not always rational actors. The relations between money supply, inflation and currency values are not linear and difficult to measure and to simulate and those are only three indicators of a myriad of highly interdependent others. Economics is not a strong science.

Still historic experience confirms most of these relations and trends. Quantitative easing is nice to have as a Keynesian instrument in a temporarily deflationary environment. But two or three years on it usually comes back biting in the form of strong inflation that easily can tip over into a high inflationary environment. 

The world could avoid a big chunk of the now needed quantitative easing if it would consider not to back up some of the irrational contracts that this or that financial entity made. Declare All Credit Default Swaps Null And Void, separate good from bad banks and assets and start over with simpler and cleaner balance sheets.

It would not be simple to do and it will be unjust. But it will be much faster in ending the crisis and thereby in the end be more benevolend for all to go that way.