Fed can only choose the least-worst option now: either destroy the real economy by sinking the dollar below support and unleashing the Inflation Monster, or abandon the "risk trade" stock market rally.
The Fed's game plan--sink the U.S. dollar to goose corporate profits, reinflate asset prices and create "modest inflation"--is now the most dangerous game on Earth. As overleveraged assets from real estate to stocks imploded in 2008 and early 2009, the Federal Reserve rushed to flood the global economy with zero-interest dollars. This did a number of things the Fed reckoned were necessary:
1. It gave U.S. banks and other insolvent financial institutions an unlimited pool of money to borrow at zero interest and leave on deposit at the Fed, where it earned risk-free interest.
2. It enabled a vast global "carry trade" in dollars: speculators could borrow unlimited dollars at no cost, and then deploy the cash around the world to chase higher yields in stocks, commodities, etc.
3. It allowed banks to lend profitably in the U.S., as their cost of money was reduced to essentially zero, and to pour "hot money" into U.S. stocks, creating a virtuous cycle of ever-rising equity prices.
4. With the bulk of U.S. corporations' growth and earnings coming from overseas sales, then a plummeting dollar boosted their profits effortlessly, further goosing U.S. stocks.
5. With savings earning nothing, U.S. investors were driven into the "risk trades" of the stock market and commodities, a flow of funds which reinflated asset bubbles. This reinflation was critical to foster the appearance of widespread "recovery" via the "wealth effect" of rising asset prices.
6. A rising stock market not only offered an illusion of "growth" but it bailed out pension funds and set the stage for Wall Street to reap billions of dollars from the resurgence of mergers and acquisitions, IPOs and derivatives.
The basic idea was to extend the game plan which had worked in the last banking crisis in the early 1980s: don't force the banks to declare their losses, but "extend and pretend" while offering them risk-free ways to bank billions in profits. The goal was to enable the banks to recapitalize "painlessly" on the backs of consumers and taxpayers.
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