and more from his counterpart Marty Guild:

FOR THOSE WHO THINK THAT DEFLATION WILL BE A LONG TERM OUTCOME

May I remind you of the words of Milton Friedman, who said "Inflation is always and everywhere a monetary phenomenon".

My money is on Milton Freidman. He will be proven correct as the devastatingly inflationary monetary policies being pursued worldwide will lead to inflation in years to come. His former co-author, Anna Schwartz, said as much in a recent Barrons’ interview, inflation will return.

I lived through the inflation of the 1970’s and have been a student of inflations worldwide for 40 years. In past recessions (much like today’s), as the recession/depression starts to get underway, it can initially appear to be a dis-inflationary cycle as prices moderate for a few months.

We go through a large amount of economic data every month. A tremendous amount of liquidity has been added to the global banking system, but the system has not yet engendered enough confidence for it to function. As confidence returns to the system, all the money circulating will ignite inflation. If confidence does not return to the system, we expect even more and more liquidity pumped into the system…which can create the possibility of a loss of confidence in the government’s ability to manage the problem. This will likely set off a run on the currency. In other words, if the U.S. continues its rapidly growing liquidity creation, and it does not create confidence in the banking system…eventually confidence in the U.S. Government will be damaged…and the world investors will not want to hold the main asset of the U.S. Government, its currency.

In this case, the country’s currency becomes an unattractive investment, because of the perception that the government has failed to bring order to its banking system. Recent examples are Iceland and Zimbabwe. In both cases, when the banking system failed, the currency collapsed.

POLITICIANS PANIC

Meanwhile, politicians are panicking. It is not good for their re-election prospects to have a slow and sluggish economy. Their constituents want benefits, they want restrictions on imports, they want handouts, they want special treatment for their industry, and they want government loans for themselves or their family. Eventually, whole classes of citizens (the poor, the homeowners, those in certain states or professions) will be lining up for their share of the pie. Politicians listen, and act in their own best interest…which for most of them is protecting their place at the public trough.

Eventually, the effects of the unwise, inflationary monetary and fiscal policies (which are being promulgated not only in one country, but in many countries worldwide) begin to seep into the system. Inflationary psychology takes hold, and rational investors begin to invest for inflation. The final result is prices rising higher…and for longer.

THIS IS THE FUTURE AS WE SEE IT…THE QUESTION IS…WHEN WILL INVESTOR PSYCHOLOGY REFELCT THIS EVENTUALITY?

The following article found in this past weekend’s Barrons illustrates how the U.S. Central Bank’s inflation fighting ability is being compromised.

Has the Fed Mortgaged Its Own Future?
By: JACK WILLOUGHBY
The fed’s highly leveraged balance sheet will make it hard to fight inflation.

IF THE FEDERAL RESERVE BANK WERE A COMMERCIAL LENDER, it would be a candidate for receivership, based on its capital ratios. Bank examiners generally view any lender with a ratio below 2% to be dangerously undercapitalized. The Fed’s current capital ratio, or capital as a percentage of assets, is 1.9%.

The Fed has provided so many loans and emergency credits — to banks, brokers, money funds and foreign countries — that its balance sheet, viewed one way, is as leveraged as any hedge fund’s: Its consolidated assets amount to 53 times capital. Only 11 months ago, its leverage on this basis was a more modest 25 times, and its capital ratio 4%. A caveat: Many of the loans are self-liquidating facilities that will disappear in a few months if the financial crisis eases.

Although the Fed’s role as a central bank is much different from the role of a private-sector operation, the drastic changes in the size and shape of its balance sheet worry even some long-time Fed officials. Its consolidated assets have swelled to $2.2 trillion from $915 billion in about 11 months, and contain at least a half-dozen items that weren’t there before. Some, like a loan to backstop the purchase of a brokerage, Bear Stearns, are unprecedented. (See table for highlights.)

Critics say this action could hinder the Fed in achieving its No. 1 priority: keeping inflation in check. To try to get in front of the crisis, many decisions have had to be made on the fly.

"If the Fed had been [a savings-and-loan] ballooning its balance sheet so fast, the supervisors would have been all over it," says Ed Kane, a Boston College finance professor.

Adds Walker Todd, a former Fed lawyer: "The Fed has stretched its authority farther and wider than it ever has in its entire history. The risk is that they won’t be able or willing to mop up all this excess liquidity when it comes time to head off inflation a few years down the road."

How did the U.S. central bank, under Ben Bernanke, get to this place? The boldest move hit the headlines on St. Patrick’s Day, when the Fed made its unique 10-year loan to bail out Bear Stearns by backstopping JPMorgan Chase ’s (ticker: JPM) purchase. That was done, some say, to prevent the domino effect that Bear Stearns’ collapse might have had on certain big counterparties, including banks.

In September, the Fed provided $85 billion to American International Group (AIG), effectively taking control of the world’s biggest insurer in a deal that’s since been restructured. And the central bank has poured so many billions into the commercial-paper and money-market mutual-fund markets that one in every seven dollars, about 15% of the $1.6 trillion commercial-paper market, is Fed-supported.

The Fed also created special lines for London offices of primary U.S. government dealers after the Bank of England cut off its short-term lending to them because Lehman Brothers repatriated $8 billion to New York from London just before its bankruptcy filing.

Then came the $571 billion in foreign-currency swap lines funded and operated by the Fed. The last time swap lines were used in a major crisis, the so-called Exchange Stabilization Fund — to bail out Mexico in 1995 — was operated by the Treasury and Fed.

The Fed has its supporters. "Given the alternative — doing nothing in the face of a crisis — the Fed has done a remarkable job of holding the system together by inventive use of short-term liquidity," says Charles Blood, senior strategist at Brown Brothers Harriman.

Yet others see a willy-nilly series of moves that didn’t weed out insolvent banks. Boston College’s Kane blames Treasury Secretary Henry Paulson for frightening Congress into parting with $700 billion. Kane’s view is that the Fed’s independence has been compromised by working too closely with Treasury.

For all that, banks remain reluctant lenders, because no one’s sure who’s solvent. Reserve balances held with Federal banks now rest at $592 billion, up from the normal $15 billion in the months prior to September.

"The Fed has violated two principal tenets of central banking," says Lee Hoskins, former president of the Cleveland Fed: "First, don’t lend to insolvent institutions, and second, don’t lend on anything but the most pristine collateral" — and at a penalty rate.

In lending and selling off most of its hoard of U.S. Treasuries, the central bank may not have the resources to sop up all the liquidity. Its current accounts show that the Fed’s holdings of Treasuries not already lent to dealers have dropped to about $250 billion, the lowest level since the late 1980s.

The Bottom Line
In attempting to calm the financial crisis, the Fed has more than doubled the size of its balance sheet. Yet insolvent lenders still lurk — and so does the specter of inflation.

The Fed needs at least $48 billion more in capital to return to 2007 levels, just to meet the standard it demands of banks, says Gerald P. O’Driscoll, a senior fellow at the Cato Institute and former vice president of the Federal Reserve Bank of Dallas. And some of that capital might go into reserves to shield against unanticipated loan losses. "[The Fed has] spooked the market with [its] scare tactics and ever-changing plans," he says "The Fed’s actions coupled with the Treasury’s bailout of the banks have taken us one big step closer to corporatism — big business in cahoots with big government."

It’s possible some of the better-capitalized regional Fed banks may balk at some point. "Of course, there are plenty of regional Reserve bank presidents and directors deeply concerned about what the Fed has done," says Hoskins. "But how do we register that concern?"

THE MARKET HAS RALLIED, AS WE EXPECTED. THE RALLY WILL CONTINUE UNTIL THE NEXT BANK MELTS DOWN.

VOLATILITY WILL CONTINUE, SO BE A NIMBLE TRADER IN THIS MARKET.

Thanks for listening.