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The Fed's Jedi Mind Trick

Stocks in this article: ^DJI ^GSPC TLT JNK SPY QQQ DIA

NEW YORK ( TheStreet) -- The Fed understands that it must quickly wind down QE, lest the experiences of 2001 to 2007 be repeated. During this fateful period, the Fed maintained too much monetary accommodation for too long (2001-2003), and then failed to remove the excess liquidity from the economy in a timely fashion (2003-2007). The result was the formation of asset bubbles and relative price distortions, which ultimately led to devastation of the U.S. financial system and overall economy.

Still, cognizant of these risks, many Fed officials are also concerned that economic growth in the U.S. is very weak and vulnerable to reversal. These officials fear that removal of monetary accommodation could trigger instability in credit markets, which could in turn derail the weak recovery being experienced in the real economy.

What will the Fed do in the face of this dilemma? They have apparently decided that Jedi mind tricks are the answer. By confidently uttering things that are both suggestive and a bit mysterious, the Fed hopes that it can keep bond vigilantes bamboozled and stock bulls from running wild, while at the same time continuing to pump liquidity into the economy ostensibly to support the real economy.

Specifically, Fed officials hope that mere suggestions about tapering, combined with confident bragging about the Fed's ability to swiftly withdraw (or to accelerate) accommodation, if conditions warrant, will be sufficient to persuade investors not to bid down the price of fixed-income assets such as iShares Barclay's 20+ Year Treasury Bond (TLT) and SPDR Barclay's High Yield Bond (JNK) (thereby increasing their yields), despite growing signs that excess liquidity is igniting inflation in select sectors of asset and product markets.

To understand the magnitude of the Fed's challenge, you must first ponder the following graph, which illustrates the enormous level of excess liquidity that has accumulated in the U.S. financial system and economy.

During the early phases of the recovery from the 2008 financial crisis, this unprecedented level of liquidity pumped into the system by Fed policies did not pose a problem, and was indeed helpful to the economy, as long as the demand for liquidity (liquidity preference) was high.

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