Fed May Keep Foot on Accelerator into 2011

"Now, the Fed is saying: We stopped prematurely."
  - David Wessel, WSJ 10/14/2110, "For Fed, Goosing Markets Is a Risk Worth Taking"

"Mr. Bernanke felt that Japan's central bank needed to make a commitment to get inflation higher and keep policy accommodative until it increased. Among his proposals was a suggestion that the bank publicly adopt an inflation target of 3% to 4%."
  - Jon Hilsenrath, WSJ, 10/12/2010, "Fed Chief Gets Set to Apply Lessons of Japan's History"

"China’s stockpile of currency reserves, already the world’s biggest, increased by $194 billion from July to September, the most ever in a three-month period, to reach $2.65 trillion."
  - BusinessWorld, 10/13/2010, "China’s foreign reserves soar to $194B in Q3"

"The central bank doesn’t want to see excessive liquidity and is seeking to send a slightly tighter signal to the market"
  - Chen Qi, a Shanghai-based fixed-income analyst at UBS Securities Co., 10/11/2010

Tension continues to build in the world economy. The Fed appears intent on an expansionary monetary policy to fend off deflation and boost the U.S. economy. In China the policy makers continue to intervene in exchange markets to avoid a rapid rise in the yuan, which would hurt their export-based economy. As a result, the Chinese are buying dollars in their reserves, issuing yuan, and tightening their monetary policy to avoid inflation. So you have the Fed pushing on the accelerator and the Chinese pushing on the brakes. How this tension eventually unwinds will likely have a strong influence on my investment decisions in 2011.

My assumptions are the following:
(1) The Fed likely keeps flooding the markets with U.S. dollars into next year, in my view. This boosts the equity markets and eventually swings treasury yields higher (conflicting forces between Fed buying of treasuries versus improving outlook and rising inflation potential). I believe it is in Bernanke's nature to keep his foot on the gas long enough to see a material appreciation in the equity markets and decline in the dollar.
(2) There is increasing pressure on China to loosen the yuan relative to the dollar. I think this becomes a self-fulfilling prophecy as increasing "hot money" flows to China in anticipation of the yuan's appreciation, making intervention in the exchange markets more and more costly to the Chinese.
(3) There may be a dramatic swing in measures of inflation in the U.S. during 2011 as the dollar falls, monetary policy remains expansionary, and the Chinese slow down dollar purchases. This likely drives up treasury yields, further erodes the dollar after a period of conflicting signals, and forces the Fed to react in a tightening manner.


So my game plan remains unchanged for now, but 2011 could become a macro minefield as real economic activity remains muted and prices become more unstable, as our walk into a gloom of sagflation takes another step forward.