Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has “run out of ammunition”–that is, it no longer has the power to expand aggregate demand and hence economic activity. It is true that once the policy rate has been driven down to zero, a central bank can no longer use its traditional means of stimulating aggregate demand and thus will be operating in less familiar territory… However, a principal message of my talk today is that a central bank whose accustomed policy rate has been forced down to zero has most definitely not run out of ammunition.

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.

-Ben Bernanke, in a November 2002 Talk on Deflation

And so we begin explicit quantitative easing, just more than six years after now-Fed Chair Bernanke gave everyone a pretty good outline of his playbook for this environment. If you haven’t read the entire speech transcript, I recommend doing so - it really offers great insight as to how the man setting our monetary policy would have approached his job on day one.

Judging from the reaction yesterday, all was right in the world. Most of the things on my screen were up in the 8% to 15% range. What to do now? To steal a saying from Minyanville, it’s all a matter of dollar devaluation versus asset class deflation. Consider how the S&P 500 has performed of late, compared to the dollar against the Euro.

In real terms, there’s nothing to prevent asset values from falling, but we can certainly do that in nominal terms through devaluing the dollar and causing inflation. This makes me nervous not just as an investor, but as a citizen. We are in a new world in terms of the intersections of economics, finance, and politics. Who is to say that turns out well, much less what the appropriate investment strategy to have is? I have batted around an idea from Cam Hui about a barbell portfolio constructed to hedge against both inflation and deflation through hard assets and risk-free paper (whatever that is today), and gold stocks generally look cheap against the price of the metal.

Another route I’m exploring is convertible preferred stock, but the rally yesterday meant that the particular one I was hoping to get an order filled for ran away from me. Hopefully it comes back.
Yes, I would prefer to have the more solid guarantee from having a convertible bond, but the underlying equity’s tax-advantaged status (and solid profitability) – along with the cumulative provision – are fairly reassuring. The perpetual call option also functions as some cheap inflation protection (having run the relative volatility numbers, I calculated an approximate 40% discount) in case adding a few trillion to the markets makes equity prices surge.

Because the non-rhetorical Fed-speak evidence continues to be quite poor – demand-driven indicators like commodities prices continue to fall, unemployment continues to rise and will likely stress the housing markets further, etc., - and indicators are offering the first signs of a tired rally, I’m content to let the bit of positive momentum of late run its course.
In the meantime, there are plenty of things that need to be considered: the marks banks will have to take, the stability of investment grade borrowers, and how much longer I can put off Christmas shopping.

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