Dan Denning takes issue with the idea that the Fed will be able to mop up the excess liquidity caused by its monetary expansion. Foreign savers are not going to keep funding US deficits forever. And that means the Fed must print more dollars to raise money. And that is super inflationary.

This from The Daily Reckoning Australia

Now to the big subject of the day: Inflation. You’d think evidence of even bigger deficits in the U.S. is clearly inflationary. But not everyone thinks so. The new prophet of doom, Dr. Nouriel Roubini, says at least four factors are setting up what he calls “Stag Deflation” (as opposed to the stagflation of the 1970s, where you had no growth and rising prices).

Roubini’s four forces of Stag Deflation are: a slack in goods markets, a “recoupling” of the rest of the world with the U.S. recession, a slack in labor markets, and a sharp fall in commodity prices. These factors would, “reduce inflationary forces and lead to deflationary forces in the global economy,” he writes in an article in Forbes.

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“Aggregate demand is now collapsing in the U.S. and advanced economies, and sharply decelerating in emerging markets,” he writes. “There is a huge excess capacity for the production of manufactured goods in the global economy, as the massive, and excessive, capital expenditure in China and Asia (Chinese real investment is now close to 50% of gross domestic product) has created an excess supply of goods that will remain unsold as global aggregate demand falls.”

You’ll have to bear with us a moment, dear reader, as we work out what this means. First, though, is Roubini right? Well, he’s certainly right that there’s a big fall in aggregate demand in the U.S. It’s obviously passing through to manufacturers and commodity producers (China and Australia). But won’t monetary and fiscal policy designed to combat deflation…you know…cause inflation?

Roubini takes that point head on. He says the liquidity measures taken on by the Fed to get credit flowing and recapitalise U.S. banks are not all inflationary. He says once liquidity is restored to the credit markets (banks begin lending, money market funds starts buying commercial paper again) the central bank can simply “mop up” excess liquidity before it seeps into the real economy to cause inflationary damage.

And what about the tendency of governments to fight debt deflation with inflation? Not a worry either, says Roubini. He says that most of the household debt in the U.S. is short-term variable rate debt that’s resistant to being “inflated away” by cranking up the printing presses. Is he right?

Well it all comes down to how much money the Fed and the Treasury are going to need before the recapitalisation of the American financial sector is over and how they plan to raise that money. The banks will probably need more capital than anyone’s expecting. And there are other landmines down the road.

In short, the Treasury and Fed will need more money. Roubini assumes the Fed can simply remove the lending backstops it’s provided once the market returns to normal. But what if it doesn’t and the Fed can’t? What happens next?

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Governments get money three ways, taxing, borrowing, or printing it. You can rule out an increase in taxes large enough to fund the Fed’s needs. It won’t happen with an economy already contracting. Even if Obama raises taxes, it won’t be enough to meet the Fed’s immediate needs. That leaves borrowing and printing.

On September 17th, the U.S. Treasury announced a Supplementary Financing Program. It initiated the program at the request of the Federal Reserve. The Fed needed the Treasury to go out and sell more bonds so the Fed would have money to fund its various lending backstops. The Fed was nearly broke.

Since then, thanks largely to the huge flight to Treasuries sparked by deleveraging and the collapse of the dollar/yen carry trades, the Supplementary Financing Account set up by the Treasury has fed the Fed nearly $560 billion. Some of that may have gone to AIG (NYSE:AIG). Some of it to Fannie (NYSE:FNM) and Freddie (NYSE:FRE). Some may go to Chrysler, Ford (NYSE:F), and GM (NYSE:GM). Who knows?

But the main point, from Roubini’s perspective, is that as long as the Fed can finance its lending with new borrowing from the Treasury, it’s not inflationary. The only thing that would make this armada of liquidity measures and loan guarantees and bailouts truly inflationary is if the Treasury couldn’t go out and sell new bonds to gullible foreign investors. As long as the Treasury can sell more bonds, the Fed can make more loans without sparking inflation.

But if we’re right and the bond bubble began bursting in late October, well then the Treasury’s line of credit with global savers is nearing an end. Global creditors will be reluctant to finance American deficits. In order to borrow, the Treasury is going to have pay much higher rates of interest to reflect the credit risk the U.S. government has become.

Trouble is, the U.S. can’t afford to borrow at higher interest rates right now. So that leaves the option Roubini thinks is least likely: printing money. The fancy term for it would be “monetizing the debt.”

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That means the Fed would buy public debt issued by the U.S. Treasury with freshly printed money. And THAT, we reckon, is super inflationary. Any time you start rolling out new greenbacks to pay for new bonds which you give to corporations in exchange for their garbage securities, you’re going to damage the confidence people have in the currency (the U.S. dollar).

But then, Roubini has been right about an awful lot lately. It’s possible the Fed will not be forced to monetize the debt. It’s possible that a global contraction is truly deflationary. We don’t really know. But we’re not nearly as sanguine as Roubini that you can expand the monetary base as quickly as the Fed has and be confident it can all be mopped up later without causing inflation. Try getting motor oil out of an engine and back into the bottle.

Source: Falling Commodities and Inflation in the Wings