Testifying before the House Budget Committee this week, Ben Bernanke said that when the time comes, the Fed will raise interest rates in order to stop inflation from building in the next recovery. He also asked for “fiscal balance” to sustain financial stability. On the surface -- in terms of keeping prices stable and restoring value to the softening U.S. dollar -- this is positive. Surely Mr. Bernanke wants to do right for America, and he’s giving it his best shot.

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But when you talk to traders and economists, the whisper story is that Bernanke and the Fed are no longer truly independent of the Obama White House and Treasury. As a result, Bernanke will not be able to slow down the printing presses and gradually lift the near-zero target rate in a timely and effective manner. Already the Fed has created more than $1 trillion in new cash, and the M2 money supply is growing at its fastest pace in 25 years.

This monetary explosion explains what’s really driving the dollar down and Treasury rates up (alongside rising gold and oil prices). It’s not huge budget deficits, but the growing fear that a less-than-independent Fed will keep pushing new money into the financial system in order to fund Obama’s liberal spending policies. 

This week, German chancellor Angela Merkel launched a broadside against the Fed, saying she views the Fed’s powers “with great skepticism.” It was an important rebuke. Here’s the elected leader of a major country actually telling a central bank to stop the printing presses and avoid creating yet another inflationary bubble during the next recovery cycle. In other words, it’s the printing presses, stupid.  

Rising inflation and interest rates are always a monetary problem. When Dick Cheney said a few years ago that deficits don’t matter, he was basically right. There is no clear relationship between budget deficits, inflation, and interest rates. In fact, for most of the’80s and ’90s, and much of the 2000s (excepting the 2003–05 bubble), interest rates and inflation fell while deficits averaged over $200 billion a year and got as high as 6 percent of GDP at some points. This is because Paul Volcker and Alan Greenspan restrained money-supply growth in a non-inflationary manner.

Now surely today’s $2 trillion deficit -- which is 13 percent of GDP and likely to remain very high -- is a shocking number. But if the Fed refuses to monetize the deficit, inflation will stay low and long-term interest rates will normalize. Conventional economists and most politicians do not understand that excess money is the root cause of inflation, spiking rates, and a bad, unwanted dollar.

Unfortunately, with the Fed purchasing Treasury bonds, mortgage-backed securities, and other asset-backed bonds, the growing suspicion is that Bernanke & Co. is too entangled in Obama economic policy. Therefore, a timely Fed exit strategy is just as unlikely as a timely fiscal exit strategy to remove unnecessary budget spending and TARP money.

With clear signs of economic recovery on the horizon, some are now calling for an end to the unnecessary stimulus package and a de-TARPing across-the-board. Along with a big rise in the money supply, there’s been a rebound in commodities, a stabilization in housing, falling unemployment claims, a booming stock market, narrowing credit spreads, and rising ISM manufacturing reports. All this is telling us that additional stimulus is unnecessary. Continued...