I and many others have been discussing this very topic for awhile. My contention has been that while the first round of Quantiative Easing was engineered to prop up all kinds of asset classes, most notably the housing market (in that case to slow the free fall) and the stock market. QE-I is about to run out (the Fed MBS purchase program ends this month). And I have stated before that there will be a Quanitative Easing Two / QE-II [a.k.a. big bertha], only this time instead of propping up failing assets, the aim of QE-II will be soley to keep the governement running.
Why? Because of debt saturation.
I talked about this very issue in my December post: The Long View - Q&A:
this Dollar bounce was not unexpected either. Many of us have been watching and calling for it. The question is now, what does it signify? Is it the start of a major multi-year dollar rally (some think so), or is it a bounce that lasts a few months (I am in this camp).
I think the Dollar Carry trade is about to unwind a bit. And I think this bounce was more or less engineered. The QE fund pool is almost dried up, and the demand from foreign governements during the last bond auctions was severely anemic. So the Fed needs a good "deflation scare" to get a second round of Quantitative Easing authorized.
And the purpose of this next round of QE will be to keep the government running, not to prop up the stock market. Like you observe above, tax revenues are down, yet the national debt ceiling is being *raised*. Government is *growing* in the face of shrinking revenues. And the only way to accomplish this is through defecit spending. And if foreign governments won't buy our debt to allow our government to run, then we have to buy our own debt (via debt monetization courtesy of the Fed, of course). It is the only way to keep the government running, other than slashing services. And the chance of that happening in an election year? Approximately 0.0%.
This is why the outcome was never going to be deflationary. As long as there is Fed, debt monentization will always be the preferred expedient action.
But just because the outcome is inflationary, it does not mean that assets will rise. I hemorrhage a lot when I read economic commentary because nobody tries to understand the complexity of the macroeconomic situation. And since 2000, we have seen first hand how little the ramifcations of monetary policy decisions are made not only by the public, but even by those who are making them. I still hear a lot of "dollar down = stocks up" or "inflation means stocks will rise".
Inflation "helps" (used *very* loosely) stocks rise ... until it doesn't. Stocks can fall in an inflationary environment, because the economic fundamentals are weak, and the inflation starts to exascerbate the weakness, not hide it. This happened in the 1970s. And it is called stagflation.
When stocks fall again due to poor fundamentals, people will say this is proof of deflation. I mean after all, if assets fall, it's deflationary right? Not if you want to understand cause and effect and not if you want to understand what the macroeconomic ramfications are. Mislabelling the next downturn as deflationary is exactly the misperception that the Fed wants so that it can be more aggressive with QE and similar policies (ramp up inflation while everybody is focused on "deflation" -- which is actually a deflation scare). Hell, they even said they were buying more mortage back securities today! (monetizing debt is directly inflationary). It believes that it is helping to solve the problem, but in actuality it is reinforcing it.
Peter Schiff had a great bit on his video blog (which kdakota always does a great job of reposting) regarding the PPI interpretation and extrapolation. Check out this post: http://caps.fool.com/Blogs/ViewPost.aspx?bpid=312473 and watch from 3:05 to 5:15. It is easy to see how this argument has ramifications for lower stock prices within an inflationary environmentThe comparison between now and the 1970s has a lot of compelling aspects: high inflationary environment, poor fundamentals, and falling asset prices. The only difference now is that the structural imbalances are a lot worse. Which means that the monetary inflation is going to reinforce the problems much more than they did in the 1970s.
A valid question would be "well once the Fed realizes (supposing they do) that it is a positive term in the feedback loop, not a negative one, won't they just stop inflating?".
The first answer is: no. And the first clue is the yield curve. Nobody but the Fed is buying our long term debt. The only reason why the government is running at the moment is because the Fed is funding the Treasury, it isn't getting money from foreign governments (well it is, but in much smaller proportion). And the National Debt ceiling is being *raised*. The Fed needs to inflate to get the government running.
The second answer is: it doesn't matter. Because once the inflation is detectable in general prices, the massive monetary inflation will have already done vast amounts of damage. And because of the inertia in the economy, we will be feeling the aftermath of that inflation for a very long time.
Things you own go down in value, the things you need to consume cost more. Sounds like stagflation to me.
And there is evidence that Debt Saturation is taking place right now.
See Nathan Martin's newest post THE Most Important Chart of the CENTURY
The latest U.S. Treasury Z1 Flow of Funds report was released on March 11, 2010, bringing the data current through the end of 2009. What follows is the most important chart of your lifetime. It relegates almost all modern economists and economic theory to the dustbin of history. Any economic theory, formula, or relationship that does not consider this non-linear relationship of DEBT and phase transition is destined to fail. It explains the "jobless" recoveries of the past and how each recent economic cycle produces higher money figures, yet lower employment. It explains why we are seeing debt driven events that circle the globe. It explains the psychological uneasiness that underpins this point in history, the elephant in the room that nobody sees or can describe. This is a very simple chart. It takes the change in GDP and divides it by the change in Debt. What it shows is how much productivity is gained by infusing $1 of debt into our debt backed money system. Back in the early 1960s a dollar of new debt added almost a dollar to the nation’s output of goods and services. As more debt enters the system the productivity gained by new debt diminishes. This produced a path that was following a diminishing line targeting ZERO in the year 2015. This meant that we could expect that each new dollar of debt added in the year 2015 would add NOTHING to our productivity. Then a funny thing happened along the way. Macroeconomic DEBT SATURATION occurred causing a phase transition with our debt relationship. This is because total income can no longer support total debt. In the third quarter of 2009 each dollar of debt added produced NEGATIVE 15 cents of productivity, and at the end of 2009, each dollar of new debt now SUBTRACTS 45 cents from GDP! This is mathematical PROOF that debt saturation has occurred. Continuing to add debt into a saturated system, where all money is debt, leads only to future defaults and to higher unemployment.