The Disciplined Investor: Bernanke's Barbell

Sufficiently confusing commentary on what the Fed should do about the banks, inflation, the economy, etc. is causing me to take a step back and try to simplify the situation in order to understand the next likely moves. Here is how I boil it down, with the implications.

First, economic resources were destroyed years ago by the housing bubble, and we are now in a phase of assigning the losses. This is an accounting exercise more than an economic exercise, but it does impact the economy because all the players do not yet know who is going to lose this game of musical chairs. Because of the massive scope of the problem, losses can only be assigned in two ways:

1. to the lenders who made the bad loans; or

2. to a broad cross section of society -- that is, all of us.

So far, the Fed has decided that allowing lenders to absorb all of the losses they created would wipe out our financial system, so by necessity, the losses are going to be borne by society at large.

The question is, How do the losses get distributed? The thinking right now seems to be that inflation is an unintended consequence of the Fed's actions to stabilize the financial system; my argument is that inflation is the natural and intended outcome of the Fed program. Of course, Fed members would never admit this, but there can be no other way. You and I can take our share of the losses in only two ways:

1. the government could massively raise our taxes and send checks to the financial institutions; or

2. it can take policy actions that return liquidity to the system but devalue the dollars in your pocket.

In either scenario, you are poorer than you were before -- you are taking the loss -- but the inflation path is way more politically palatable than the raising taxes method.

So right now the Fed faces a barbell. It lowered short rates to steepen the curve, enabling banks to actually earn money to cover the mortgage losses. (Executives of banks that do not have credit issues will tell you that this is the best environment they've seen in ages; they are coining money.) Lower rates collapsed the dollar and fueled inflation, as intended. Society is absorbing the losses. If the Fed starts raising in order to "rein in" inflation, then the yield curve flattens, the banks have no profit source, and the financials start collapsing. The lenders absorb the losses rather than society at large. These are the only two outcomes.

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At the time of publication, Dvorchak was long Coca-Cola, National Oilwell Varco, Hewlett-Packard, General Mills, Oracle, Caterpillar, InterContinental Exchange, McDonald's, Honeywell, Tiffany, Microsoft, Exxon Mobil, Disney, Nucor, Flowserve, Baxter International, Archer-Daniels-Midland, EOG Resources, Occidental Petroleum and Mosaic, although positions can change at any time.

Gary Dvorchak is a managing partner of Aviance Capital Management, a Sarasota, Fla.-based institutional asset manager that manages $200 million in growth and value equities and fixed income. Dvorchak holds a master's degree in business administration from Northwestern University and a bachelor's degree in computer science from the University of Iowa.