PIMCO’s Gross QE4 Warning: Here Be Inflationary Dragons

“When central banks enter the cave of quantitative easing and ‘essentially costless’ electronic printing of money, there may be dragons,” says Gross

The holidays have come and gone, and in their wake, all the inflation fears that the Federal Reserve unleashed with its December announcement have come unfurled—with PIMCO bond guru Bill Gross leading the charge.

Bill Gross, PIMCO's bond king (Photo: AP)The Fed in its fourth round of quantitative easing, or QE4, is now writing $85 billion of checks to buy Treasuries and mortgages every month, and there’s really nothing backing those checks other than trust, writes Gross (left) in his January investment outlook, “Money for Nothin’, Writing Checks for Free.”

The future price tag of printing such checks is inflation and currency devaluation, Gross warns, while blaming the Fed’s Dec. 12 decision to set rates based not on date targets but rather on specific unemployment and inflation rate levels.

Economic growth “now is to be measured each and every employment Friday via an unemployment rate thermostat set at 6.5%,” Gross writes. “We at PIMCO would not argue with that objective. Yet we would caution, as Bernanke himself has cautioned, that there are negative consequences and that when central banks enter the cave of quantitative easing and ‘essentially costless’ electronic printing of money, there may be dragons.”

Risks Are Long Term

Gross advises investors to be alert to the long-term inflationary risk of such check writing.

“While they are not likely to breathe fire in 2013, the inflationary dragons lurk in the ‘out’ years towards which long-term bond yields are measured,” he writes. “You should avoid them and confine your maturities and bond durations to short/intermediate targets supported by Fed policies.”

PIMCO’s bond king is not alone in warning about inflation risks this January. Martin Feldstein, a Harvard professor and chairman of the Council of Economic Advisers under President Ronald Reagan, writes in a Wednesday opinion for The Wall Street Journal that the Fed is creating dangerous asset-market bubbles that will lead to higher future inflation as well as “explosive growth” of the national debt.

"The day will come when aggregate demand is increasing, companies want to borrow, and the banks are willing to lend aggressively," Feldstein says. "When the increase in money starts to cause a rapid increase in prices, the Fed will need to limit the banks' credit creation by raising the interest rate it pays for banks to keep their reserves at the central bank. That is the ‘exit strategy’ that Fed Chairman Ben Bernanke and others are counting on to prevent future inflation. Unfortunately, no one knows how high rates will have to go to restrain the commercial banks."

Dovish Fed

Even Fed officials worry that the current QE program may be going too far, according to a Bank of America-Merrill Lynch analysis of minutes released Friday by the Federal Open Market Committee (FOMC).

“About half of Fed officials expressed the view that QE could be scaled back or stopped during 2013,” write the BofA-Merrill economists and rates strategists.

But this view is contingent upon a rebound in growth, and Fed growth forecasts have been “over-optimistic” in recent years, the BofA analysis says, while predicting that the FOMC’s voters will be even more dovish in 2013 than in 2012.

If investors are worried about the specter of U.S. inflation, they need only look to other countries’ monetary policies.

Mark Mobius, the Singapore-based executive chairman of the Templeton Emerging Markets Group, wrote in a blog post Wednesday that central banks could very well continue pumping money into emerging economies given the fragile state of many of the developed markets right now—and that could spell trouble for consumers in those countries.

“The flip side of the cash flood coin, of course, is the potential for inflation,” Mobius writes. “In emerging economies, a larger percentage of the population is in lower income brackets, so price increases in essentials such as food and fuel can be harder to absorb.”

Read Inflation Boogeyman Will Strike Suddenly—Be Prepared: Merk, Goolgasian at AdvisorOne.

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