The Fed said they are prepared to buy US Treasuries outright, which is a policy action that can be analyzed from many angles, some more complicated than others. The bottom line is that it increases the probability that we end up paying for the current fiscal expansion and balance sheet problems through the inflation tax more than through the IRS. Many will tell me I am crazy to talk about this while there is deflation, but I cannot help to think that there is a limit to how much fiscal and monetary expansion we can push without eroding the value of the one asset that has become less scarce relative to almost anything else, USD. I think we continue to focus on fiscal and monetary policy in the traditional way, when the problem seems to be mostly in banks balance sheets. Only now the ‘bad bank’ idea started to gain ground, but still is a delayed third policy initiative behind fiscal and monetary expansion.

Think about it in big picture terms. The government increases its deficit in order to “jump-start” the economy. It obviously needs to issue bonds at a faster pace to fund such larger deficits. If we stop here, we would be pushing the cost of this crisis to the future (as Republicans say, make our children pay). But if the next step is the Fed to come in and buy those Treasury bonds, then the deficit would be funded with a broadly held bill that bears no interest and has no maturity… Well, now that there is deflation it does bear a positive real interest rate…

I go back to a point I think I have made too many times before in this forum: policy makers will most likely be too slow in retracting all this stimulus, both on the fiscal front as well as the monetary aggregates. Moreover, a few years of slightly higher inflation is not that bad when balance sheets are stressed by low asset valuations (say 3-5 years of say 5%, does a lot for balance sheets, especially those of commercial banks and the government).

Though this is still a deflationary environment, I cannot help to think that there will be a point in time (hopefully this year) in which a massive portfolio reallocation is bound to happen, away from nominal assets into real assets. When will that be? Well, I am still looking for my crystal ball, maybe my two sons have it hidden in the basement somewhere.

There is one relevant benefit to having a bout of slightly higher inflation, which is that the plan to address this crisis will be paid by the broader global economy, not only US taxpayers. If the inflation episode is not overdone (or it is matched in the Euro zone), the the US would be making everybody that uses USDs pay.

Conclusion: the fiscal package will most likely make people feel there is policy leadership, once approved; and, the Fed buying UST bonds will create the notion that whatever liquidity necessary to unlock capital markets and minimize further erosions in confidence will be created. But I think the third leg of the current policy approach is way more relevant: banks balance sheets. Whatever ends up being the plan for a Bad Bank is most likely more relevant than the billions to be spent through stimulus and printed through the Fed. The rest of the economy is not that much different than 2 years ago, in its capacity to produce productivity growth.