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Where the Wild Things Are is a beloved children's book and now a beautiful movie. But in the investment world there are really scary wild things lurking about in the hidden recesses of the economic landscape. Today we look at one of the unintended consequences of the Federal Reserve's low interest rate policy.

For quite some time, I have been arguing that we are faced with no good choices, not just in the US but in the entire 'developed' world. I see a low-growth, Muddle Through world over the next years (with a double-dip recession just to liven things up). However, that does not mean that we will lack for volatility. Things could get volatile rather quickly. Let's quickly set the background.

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This week we look at the second half of my speech from a few weeks ago at my annual Strategic Investment Conference in La Jolla. If you have not read the first part, you can review it in the website. The first few paragraphs are a repeat from last week, to give us some context. Please note that this is somewhat edited from the original, and I have added a few ideas. You can also go there to sign up to get this letter sent to you free each week.

MV=PQ

Okay, when you become a central banker, you are taken into a back room and they do a DNA change on you. You are henceforth and forever genetically incapable of allowing deflation on your watch. It becomes the first and foremost thought on your mind: deflation, we can't have it....

The Fed has taken interest rates to zero. They have clearly started a program of quantitative easing. What exactly does that mean? Are we all now Japanese? Is the Fed pushing on a string, as Japan has done for almost two decades? The quick answer is no, but the quick answer doesn't tell us much. We may not be in for a two-decades-long Japanese malaise, but we will experience a whole new set of circumstances. In what will hopefully be a shorter holiday version of the e-letter, I will tackle these questions and more....

A severe global recession will lead to deflationary pressures. Falling demand will lead to lower inflation as companies cut prices to reduce excess inventory. Slack in labour markets from rising unemployment will control labor costs and wage growth. Further slack in commodity markets as prices fall will lead to sharply lower inflation. Thus inflation in advanced economies will fall towards the 1 per cent level that leads to concerns about deflation. Deflation is dangerous as it leads to a liquidity trap, a deflation trap and a debt deflation trap: nominal policy rates cannot fall below zero and thus monetary policy becomes ineffective. We are already in this liquidity trap since the Fed funds target rate is still 1 per cent but the effective one is close to zero as the Federal Reserve has flooded the financial system with liquidity; and by early 2009 the target Fed funds rate will formally hit 0 per cent. Also, in deflation the fall in prices means the real cost of capital is high - despite policy rates close to zero - leading to further falls in consumption and investment....

The 'Bailout Plan' was passed. Will it work? The answer depends on what your definition of 'work' is. If by work you mean no more government intervention and no further costly programs and a functioning market, then the answer is no. But there are things it will do. This week I try to help you see what might lie ahead around the Curve in the Road. We look at how the rescue plan will function, see what is happening in the economy, and finally muse as to whether Muddle Through is really in our future. It will make for an interesting, if not very upbeat, letter, so strap in. I would like your promise to not shoot the messenger. I am just trying to give you some of my thoughts as to what may lie in our future. And remember, as you read this, we will get through it. There are better days a'coming....

Retail Sales Take a Dive Accounting for Inflation The Fed at the Crossroads Sell in May and Go Away South Africa, Flowers, and On the Road Is the economy poised for a recovery, as the stock market seems to expect? Or are we in for another few more quarters...

Muddle Through Gets A Boost Honey, I Vaporized My Customers Consumer Spending is Going, Going...South The Boomers Break the Deal Today we drop back to take a look at the economy and its long term effect on our portfolio returns. I am in Orlando this week...

How Do You Spell Stagflation? Memo from the Fed: Inflation? What Inflation? The Fed Will Cut and Cut Again Damn the Inflation Torpedoes! Full Speed Ahead! Apple, Sprint, AT&T, and Going to the Dark Side This week's topic was inspired by a discussion...