Oh Donald Kohn, you're so fucking precious. First you refuse to give up the names when grilled on Capitol Hill over recipients of TARP "loans" and now you actually want us to believe that the Fed has the ability to print absolutely insane amounts of money but will somehow be able to head off inflation? That's so cute!

Reuters:

NASHVILLE, Tenn (Reuters) - The Federal Reserve will not allow its unorthodox policies to lead to a surge in inflation, but may need to do more to ease credit if the economy fails to respond to stimulus measures, the Fed's No. 2 official said on Saturday.

But even with U.S. economy now in its sixth quarter of recession, Donald Kohn, vice chairman of the Federal Reserve, said the central bank's attempts to heal ailing credit markets and spur an economic recovery have been working, in ways that include lowering mortgage interest rates.

"The situation in financial markets and the economy would have been far worse if the Federal Reserve hadn't taken the actions we did," Kohn told a conference at Vanderbilt University in Nashville.

As the economy begins to recover, suitable policy responses by the Fed will prevent a rise in inflation, he said.

This makes for a very reassuring soundbite for those who do not understand how the Fed operates or the grave situation it has found itself in but the reality is much more complicated that that. Thankfully some get it - too bad Fedwatching doesn't make me cool among my PBR-drinking tattooed hipster friends.

Gary North has some fascinating thoughts on the Fed's dilemma via Lew Rockwell and if the Fed and Obama do not read one single article from the Fedwatching contingent, someone has got to slip this one across their desks.

North explains that while the Fed has been pumping out money under the guise of "getting commercial banks to lend again" with Congress' gun at its head, it cannot accomplish this objective without inflation. It's impossible. And likely the Fed understands as much, knowing that Basel II's capital adequacy requirement couldn't have come at a worse time and has sent us into a free-fall ever since. It was never mark-to-market accounting in particular that was to blame but the Bank of International Settlements - meanwhile, FASB bowed down and took the fall. Why would FASB do such a thing? Hmm, I wonder.

Someone alert the conspiracy theorists, they should be all over this.

The Fed knows the banks are dripping with risk and will therefore have to acknowledge massive writedowns before leaking out a penny. So the money instead lies safe in the Fed vaults until someone can figure out how to clean up the mess. And once they do, the Fed is going to have an even larger problem on its hands.

Gary North on the Fed's Self-Imposed Dilemma:

Why hasn't the Fed adopted [a] policy of a penalty payment? I think this should be obvious. Banking theory teaches that when the monetary base doubles, the money supply will double. If the money supply doubles, consumer prices will also come close to doubling. There will usually be a time lag, but the process is clear. An increase in the monetary base, which is called high-powered money, multiplies through the fractional reserve banking system. All schools of economic opinion agree on this point.

If the Federal Reserve is unwilling to impose a penalty payment on excess reserves, it is afraid that banks are going to do the rational thing: lend money to the general public. It is clear that the Federal Reserve System's policy-makers are afraid that banks are going to do what banks are supposed to do with reserves: lend money to the general public. The Federal Reserve is attempting to sterilize the increase of the monetary base, which it created. Federal Reserve economists know that if banks start lending reserves that are being held the Federal Reserve beyond the 10% legal limit, there is going to be mass inflation in the United States. The Consumer Price Index will double.

Any additional spending by the Federal Reserve to prop up the Treasury bond market will be immediately reflected in an increase in M-1. Long-term interest rates will soar. The market for Treasury bonds will collapse. At that point, the Federal Reserve will have to intervene and purchase Treasury bonds. This will drastically raise interest rates on corporate bonds and mortgages.

The Federal Reserve is now trapped by its own policies. It has dramatically increased the monetary base, and it does not want this money to be spent into circulation. Federal Reserve economists understand the fractional reserve banking process. They know that the only way that the M-1 money supply will not match the doubling of the monetary base is for the Federal Reserve to impose an increase in the reserve requirement. It has not done this. Instead, it has paid a small amount of interest to banks to persuade bankers to see keep money on deposit with the Fed, which sterilizes the increase in the monetary base.

If banks begin lending money to the general public, the Federal Reserve will have to sell assets in order to offset the increase in its balance sheet, which is a result of the big bank bailouts and buying T-bills. The problem is, the Federal Reserve is running out of Treasury debt certificates to sell. The only asset that the Federal Reserve now holds in its balance sheet that can be sold at face value to the general public is Treasury debt. There is no way for the Federal Reserve to unload the toxic assets that from the banks.

So while the Fed may have the best intentions when it comes to inflation, if it accomplishes the "officially announced" goal of getting banks to lend again (which goes against the Fed's common sense, mind you, but they've got to play along), thereby unleashing the deposits it is clinging to on behalf of terrified commercial banks who would rather lose interest payments than risk default, we're fucked.

And not only are we fucked but we're fucked hard.

This is because the Fed does not have the ability to sterilize this much money. It simply cannot accomplish as much; which may be why Janet Yellen is yapping on about F-bills in lieu of Treasury securities.

So you see, kids, it's a lose-lose. And it's a lose for us because if the banks do start lending again, you can kiss the dollar goodbye. But as is, they've got the Fed sitting on their money and don't care that they are actually losing money on this; it doesn't matter to them as it's safer than taking a risk and would require them to come up with an additional 8% in capitalization to cover BIS requirements.

But we'll talk about BIS and how they are bending us over later.