Ben Bernanke told us five years ago he would inflate to no end.

Now he's making good on his word.

Ever wondered why long term interest rates are so conveniently falling in sync with the official need to avoid troubled-loan ARMs to reset significantly higherin early 2008?

Ever wondered why in an environment of increasing raw material prices and dropping US currency values that must surely lead to higher price-inflation in the future, long term US treasury rates would fall (which normally indicates rising treasury prices due to increased investor-demand)?

In 2002, the horse's front-end spoke thusly (leaving widespread doubts whether the words might actually have come out of the other end, maybe):

"The Congress has given the Fed the responsibility of preserving price stability (among other objectives), which most definitely implies avoiding deflation as well as inflation. I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States and, moreover, that the U.S. central bank, in cooperation with other parts of the government as needed, has sufficient policy instruments to ensure that any deflation that might occur would be both mild and brief."

"Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."

"A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well."

(Then Fed-governor, now Fed Chairman Bern Bernanke before the National Economists Club, Washington, D.C., November 21, 2002)

If Bernie was "confident" then that the Fed might do such a thing, he is at the point of absolute certainty today, where he largely controls how it operates. (The only thing he didn't make good on was his promise to "announce explicit ceilings" on long term government debt. It's all being done in secret.)

What Does It Mean?

In essence, he stated that the Fed has the option to manipulate long term yields by conducting Open Market Operations (OMO) on long term treasuries when the short term rates hit or go near zero. Today, that is not the case. Short term rates are well above zero, but recent rate cuts have failed to improve the financial picture significantly. Short term rates cuts are also not effective in affecting long term mortgage rates - which are crucial at this point.

In addition, we are facing a serious housing slump and record mortgage defaults, first in the subprime sector and now in even solid mortgages, coupled with looming ARM resets in 2008. So, what could be more logical than to conduct long-term OMOs even while the short rates are nowhere near zero in order to make sure that any ARM resets in the coming year will be flat to downward rather than upward?

How Does It Work?

In doing this, lots of banks and other lenders (uhh, I meant homeowners, of course. Officials must always pretend their primary concern is for consumers, even though we all know it is otherwise) can be spared foreclosure. What's even better, in coordination with the major financial news outlets, this strategy can be used to fake out investors by making them believe the dropping long term rates are the result of "flight to quality" shifts from the stock market to government debt markets, thereby creating an illusion of continued wide-spread confidence in the jerry-rigged, debt-based US fiat dollar system.

The actual evidence, as usual, points the other way.

So, Who's Buying?

Foreigners, especially the oil producing nations (and that includes Saudi Arabia) are gearing up to abandon the petro-dollar system altogether. China is seriously slowing its purchases of US treasuries as a matter of open policy. Examining the Treasury's TIC data, the only remarkable thing about them is how - unremarkable they are. The picture hasn't drastically changed since last year and the years before - so why is there this sudden surge of alleged demand for US long term debt that causes yields to freefall?

Although the Fed doesn't publish any figures showing its actual OMOs, the general investment climate and world-wide dollar aversion makes it pretty clear that it isn't the foreigners who are buying into long-term US Treasury bondage. There is likewise little reason to believe that the majority of Americans are really dumb enough to fall for that ruse - although there undoubtedly are some, at least. That leaves only the US Fed as a major player.

Whether this is done directly and exclusively by the Fed or by it in conjunction of major banks' manipulating interest rates through their various derivative instruments as first-rate commentator Jim Willie noted in his latest post - or whether it is a combination of both - is difficult to determine. However, knowing how these people operate, the combo-approach is probably the most likely scenario.Bernie has signaled his willingness to buy long term government debt way back in 2002. It is not too far of a 'fetch' to expect that he is now further pushing on the door knob he turned and opened, way back then.

So, what can we expect if this continues?

Inflation, on the one hand. On the other - deflation.

As to the immediate and practical consequences, those ARM buyers who would have been exposed to higher rates - had the long term yields continued to rise into 2008 (as they were set to do until as recently as July 2007) - are being bailed out. They may be able to anticipate flat to even dropping rates. They may well be the intended beneficiaries here, along with the banks who made the loans who are now relieved to know they don't have to write them off as "bad" ones.

Good policy? Smart move?

The Consequences:

No. Lots of Americans are being suckered into buying long term treasuries as a result (they are going "up" in price, after all, promising illusory future gains to the gullible). Their real returns will be negative, especially since inflation is far higher than the government "reports."

Banks are now forced to be much more cautious than they want to be in selling further loans. They literally and figuratively don't make money unless they get you further into debt, so that's bad for them. Despite lower long and short term rates, fewer loans will be made. As the banks' asset base shrinks from the subprime mortgage fallout (loans that were once "assets" are written off resulting in losses) bank regulations do not allow them to pyramid as many new loans on top of the old ones as they did before.

What's more, even those loans created under the stricter guidelines will be harder to sell to investors - who are now extremely wary of them. The result: originated loans will tend to remain on the lenders' books as both an asset and a liability, creating a wash. They will have a harder time selling their toxic waste off by dressing it up as an "asset".

It remains to be seen whether Bernie will go all out and counter this by actually lowering the banks' reserve requirements. If he does, more sub-slime mortgages will be created and the problem gets worse. If he doesn't, then the resulting credit contraction will cause deflationary pressures whether or not he buys long term treasury debt with printed money.

In other words: his last remaining policy tool will be out the window, as well.

Then, watch what happens!

An Actual Solution? No Way!!

It would be far better to allow Americans to freely trade gold and silver as currency by taking off all taxes on these metals (exactly the way federal reserve notes aren't taxed if they "increase" in forex value.)

Then, Americans could protect themselves, rather than having to wait on their government to screw things up for them.

With gold in full circulation as a medium of exchange, it could compete with dollars. People could buy and exchange gold for products. Businesses could sell their wares for gold and pay their suppliers with gold. Everyone, especially businesses and thereby employers, could thus accumulate a nice inflation and deflation-proof wealth base that misguided government policy would be unable to screw up, all without the unnecessary accounting hurdles currently imposed by the prevailing taxing scheme.

Of course: since when is government in the business of making things right for regular people? If it was, government officials and their appointees would make themselves obsolescent in the process. That's not gonna happen - unless Ron Paul is nominated as the GOP's presidential candidate of choice.

Yet, there is a possible avenue for lower-income small business owners to avoid capital gains taxes on their gold receipts, should they choose to sell products for digital gold and silver currency. (Remember: Tax avoidance is legal. Tax evasion is not. But that will be the subject of a future article soon to be published here.

Anyway, at least now we know what's been happening - and we got it straight from the horse's mouth.

Got gold?