Eulogy to the Fed
If I have to choose a sociopolitical label for myself, I'd have to pick libertarian, although some in the Tea Party make me nervous. So I was instinctively against the Fed since QE1, and later QE2. Then as time went on and the inflation I feared never materialized, I began to rethink it.
QE1 was quite necessary, unlike the panic bailouts done by the Paulson administration. QE2 did push inflation expectation to uncomfortable levels and caused worldwide commodity (especially food) inflation, which was an important trigger for the Arab Spring that seriously damaged U.S. interest in the Middle East, probably permanently. But the Fed had its eyes on the ball.
I especially admire Chairman Bernanke, in retrospect, for calling the inflation pressure "transitory" in early April, 2011, which I was guilty of ridiculing at that time. He turned out to be right. Inflation expectation started to come down by the end of April. Maybe he had some pretty darn good forecasting models and he believed it. But in retrospect the five-year inflation expectation never quite reached 2.5%; if it had and stayed there for more than a week or two, he probably would have been forced to do something about it.
Here it is again, my favorite graph, updated.
As the graph shows, Twist 1 and Twist 2 were both done for very good reasons; inflation expectation was dropping and the risk of deflation was clearly outweighing that of inflation. I began to appreciate the importance of balance; Fed had done an excellent job at walking the tight rope. Ray Dalio gave by far the best explanation of this point in his recent interview with the Free Exchange blog on The Economist Web site. If you have any interest in macro-economic issues or macro-investing, it's a must-watch.
Dalio said repeatedly that his biggest concern is losing the balance between deflationary deleveraging and money printing. Sorry, Mr. Dalio, your worst fear just came true, on 9/13/2012.