The Fed loses control of inflation…

The world is in danger of a "global stock and credit crash," says the Royal Bank of Scotland.

A "very nasty period," may be coming, it goes on, as "the chickens come home to roost."

Morgan Stanley also warns that a 'catastrophic event' may be coming, caused by the collision between Europe's tight monetary policy and America's loose one.

Surging inflation all over the world is putting pressure on the Fed to raise rates. But raising rates in an economy with rising employment and falling house prices could be disastrous.

On the other hand, not raising rates could provoke a disaster of its own. It could cause the dollar to collapse as prices soar.

On Friday, the Dow fell 220 points. Gold held steady at $903. Oil rose $2 to $135.

Here at The Daily Reckoning headquarters our "Crash Alert" flag has been up so long it's almost in tatters. Even we don't bother to look up any more. We know what to do - keep our money in cash…in gold…in Japan…and, lately, in emerging markets.

But the best place for you money over the last year has been energy. Energy stocks on the S&P are up about 20%. The worst place for your money has been the financial sector, which is down about 36%. The banking index, BKX, was at 110 last year. Now, it's below 65, down about 40%.

The Fed is fighting a mighty war against deflation…and losing. Its cheap money and credit no longer seem to help its buddies on Wall Street or the little guy out on the prairies or down in the bayous. Instead, the money drives up consumer prices…and ends up in the hands of the energy exporters - Russia, Venezuela, and the Gulf. The Financial Times reports that there are 15 times as many houses for sale than there are buyers looking for them. And now, it appears that the very temporary boost given to the U.S. economy by the tax rebates is fizzling out. Look out below…

But you rarely get what you expect from the financial markets; instead, you get what you deserve.

Wall Street is getting what it deserves. The hotshots made fortunes by loading up the whole country with debt. Finally, they're taking some losses.

This point deserves a brief pause. Stephen Cecchetti, writing in the Financial Times, argues that Wall Street's innovations of the last 20 years were a great thing, in that they helped cause 'the Great Moderation.' He's referring to the period of steady growth, with less volatility, over that period. The key to it was securitization, he says. By turning loans into credit-backed securities, the financial industry not only did itself a huge favor, it did the whole world one too, he believes.

How so?

"Not only has the overall quantity of financing increased, but also these innovations have allowed high-risk borrowers access to financing…there is a clear sense that financial innovation has been responsible for reducing the previously direct relationship between consumption and income."

Mr. Cecchetti, a professor of finance, sees this extra credit as a triumph. We see it as an attractive nuisance. Like a hand grenade on a playground, the kids are bound to start playing with it…until it blows up.

In 1985, there were only $1.6 trillion in home mortgages. And only $500 billion worth of them were in pools used to back securities. Twenty years later, total mortgage debt approached $10 trillion, with $7.5 trillion of it securitized.

This "financial innovation has been responsible for reducing the direct relationship between consumption and income," he adds.

Again, the professor regards this as a victory. To us, it is the kind of victory won by George Armstrong Custer at the Little Big Horn. The financial innovations of the last 20 years lured Americans to go deep into dangerous territory - increasing their spending, even though their incomes were stagnant. This "smoothed" growth in the world economy. Economists loved it. But it wasn't long before the U.S. consumer had slumped over - wounded by excessive debt.

America's central bank tries to come to his rescue…but when the cavalry finally arrives, they gallop right over him.

*** What the U.S. economy desperately needs and richly deserves is a slowdown. People borrowed too much…and spent too freely. Now, they have to cut back and pay up. The sooner they get it over with the better; clearing away excessive debt and cleaning up balance sheets will give them something solid to build on. Of course, it won't be easy or painless. Before it's over, the spendthrift consumer will feel like a Zimbabwe voter.

But the Fed is doing all it can to avoid a slowdown. That is why we have the key Fed rate at a NEGATIVE real yield of 2.2%. And it's why when you put money in a money market fund you get a return of less than half the rate of consumer price inflation. The low rates discourage you from doing what you ought to be doing - saving money rather than spending it. The 90-day T-bill rate is only 1.8%. That's part of the reason gold is so expensive; you don't give up much income to own it.

Usually, the regret phase of the financial cycle has its own rewards. There are fewer cars on the road…and it is easier to get a reservation in a fancy restaurant. And when people begin cutting back on spending it causes consumer prices to fall. But those were in the good ol' days. Now, the economy has gone global and the U.S. Fed no longer controls inflation. Prices are no longer set by America's 300 million consumers…but by Asia's three billion consumers.

Bill Bonner is the President of Agora Publishing. For more on Bill Bonner, visit The Daily Reckoning.