A thought. By now, the US Federal Reserve’s quantitative easing strategy is well underway, with the central bank pushing as much cash as possible into the hands of private commercial banks, hoping that they will then take the money and distribute it throughout the economy in the form of loans. Check out excess reserve balances with the Fed, essentially the cash that has been placed into bank vaults by Bernanke and co. and that is available for lending into the fractional reserve system. This went from US$1.9bn in August to US$267.9bn in October. That is an increase of 13,376% over that span, and of 18,262% y-o-y. And this measure surely went higher in November, and will go even higher.

US - Excess Reserves of Depository Institutions (% chg y-o-y)

Unfortunately, this doesn’t seem to be working, at least yet. And deflation now looks like destiny.

I’m a deflationista, par extraordinaire. But it is not hard to see how if the Fed gets aggressive in purchasing all manner of assets, from stocks to real estate to automobiles (hey, it is possible, if Bernanke gets desperate) to commercial paper to government securities, the dollar would begin to weaken and its purchasing power would wane. That’s called inflation. And if an inflationary scenario eventually emerges, the Federal Reserve would have little option but to tighten policy.

The difficulty is that nobody seems to have given any thought to how quantitative easing will end. Given the degree of monetary stimulus injected into the economy over the past 12 months, and the unconventional means through which it has taken place, it could be extremely difficult to unwind. The Fed would also have to decide whether it would be better to attack inflation aggressively and quickly, or to change policy gradually, hoping for a soft landing. I think that either way, serious dislocations in the economy would ensue.

US - Quarterly y-o-y GDP Growth Comparison (T=Q409 and Q480)

What is this all leading up to? Well, while most people are focused on the current recession, I’m already becoming somewhat concerned about the next one. I can envisage a deep contraction in the US (the one we are in now), with a trough in mid-to-late 2009, but with a subsequent return to trend growth stunted by the Fed’s obligation to begin unwinding quantitative and conventional monetary easing. The scenario here would be most similar to the 1980-82 double-dip recession, punctuated by then-Fed chairman Paul Volcker’s decision to shoot the funds rate up to 20% in an effort to kill inflation once and for all. Any way you look at it, the Fed’s choices are going to become more difficult, not easier.