(snip)"Is it reasonable to forecast zero inflation and historically low interest rates for this year and the foreseeable future?

While the credit freeze of the fall of 2008 triggered powerful deflationary forces, especially in commodities and real estate, we expect the impact of monetary expansion to have a measurable inflationary effect as early as the second half of 2009.

The U.S. government needs to roll over $2,596 billion of outstanding Treasury bills and notes coming due in 2009 before it can add any new borrowing to finance the expected deficit. In previous years, foreign investors have invested most of their trade surpluses - to the tune of $200 billion to $500 billion per year - in Treasuries and agency debt. We cannot expect this trend to continue as we go forward, especially given that China, Japan, and the Middle East are experiencing a sharp decline in their exports and have indicated that they will have to support their own economies with massive stimulus packages. These actions will further reduce their propensity to buy U.S. debt. The Treasury Department recently reported that in January 2009, international sales and purchase of U.S. assets showed a net outflow of $148 billion. This could be a sign that "the times, they are a-changin'."

Assuming that foreign investments will not represent a large source of financing for the $4 trillion plus of U.S. Treasuries our government needs to sell this year, we will be forced to rely on domestic institutional and private investors. The problem here is that a great deal of institutional and private money has already fled from riskier categories of assets into lower-yielding Treasuries. If anything, these funds will be looking for higher-yielding investments as soon as possible.

In the absence of sizeable increases in tax revenues, it is quite clear that the lion's share of the planned sales of Treasuries in 2009 cannot be met by demand from the market. Either the Treasury will have to raise interest rates significantly, or the Fed will need to step in very aggressively to support the planned auctions. Our expectation is that both will happen. Auctions will fail and the Fed will step in. The market will react to more printing by anticipating inflation and demanding higher interest rates. Once the cycle starts, it will be very hard to pull interest rates back.

We continue to stand by our December forecast that the 2009 budget deficit is more likely to widen to levels between $2.5 and $3 trillion rather than the CBO's $1.8 billion forecast. We also believe that inflation could start setting in as early as Q3 of 2009 and will accelerate sharply by 2010. Treasury rates will start climbing and the era of cheap money will end, making it harder for overleveraged consumers, businesses, and governments to service their debt.

Monetary devaluation will be the only way for the U.S. government to shift the cost of irresponsible spending into the future. Our politicians are betting on the fact that this will happen after the next elections, thereby allowing them to continue to blame others for their reckless stewardship of the economy."(snip)