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Fed Still Walking Tightrope Between Inflation and Deflation

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Expect government to emphasize fiscal responsibility.

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To Todd's article yesterday morning, along with Branden's and Jeff's Buzz & Banter posts, I'd add that I think it's helpful to think of the Fed and the administration as having to play a very careful balancing act between the market's fears of too much inflation and deflation.

Earlier this spring, Washington played the role of cheerleader, shouting that the worst was behind us, the dollar was looking strong, there were "green shoots," and deflation was a concern they were prepared to fight with whatever tools necessary.

With the rate of economic decline slowing, rates backing up, the weaker dollar, and higher commodity prices, Washington rhetoric must now move the other direction. And in that regard, I'd highlight the following quote from the Chairman this morning:

"Addressing the country's fiscal problems will require a willingness to make difficult choices. In the end, the fundamental decision that the Congress, the Administration, and the American people must confront is how large a share of the nation's economic resources to devote to federal government programs, including entitlement programs. Crucially, whatever size of government is chosen, tax rates must ultimately be set at a level sufficient to achieve an appropriate balance of spending and revenues in the long run. In particular, over the longer term, achieving fiscal sustainability -- defined, for example, as a situation in which the ratios of government debt and interest payments to GDP are stable or declining, and tax rates are not so high as to impede economic growth -- requires that spending and budget deficits be well controlled."

This is hardly the kind of language many were looking for -- there's no suggestion the Fed is going to monetize US debt in quite the way they'd hoped.

Does that mean the Fed won't ultimately go there?

No. If the market falls off another cliff, I'd look for Washington to revert to its "we'll do whatever's necessary" language. In the meantime, though, I'd look for the government to talk down rates/strengthen the dollar by lowering the trajectory of the recovery and emphasizing fiscal responsibility.
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