The recent release of the CPI data confirms our view that "deflationary" pressures are rising in the economy. During the past several months we have been discussing, and warning about, the similarities between the current market environment and that seen in the summers of 2010 and 2011. While there was much media commentary to the contrary, we said "The market is currently playing out very similar to 2010 and 2011. Whether that continues is not important; however, with Fed support ending in June and economic numbers weakening, the environment is not currently supportive of higher stock prices." Since that time the market has been rocked with volatility as stresses from the Eurozone crisis, weakening economics and the end of stimulative support all coalesce into the perfect storm. The chart shows the composite inflation index, an average of PPI and CPI, which has declined sharply at the headline rate in the last three months as those deflationary impacts have grown.

While concerns have raged that the actions by the Federal Reserve are going to create massive inflationary pressures, the real concern for the Fed remains the deflationary threat. The threat of deflation has been the front and center of their battles since the end of the financial crisis. From bailouts to Quantitative Easing (QE) to "Operation Twist", every effort has been focused on keeping the economy out of a massive deflationary spiral that would have created an economic "depression". From the Fed's point of view inflationary pressures are a much more palatable problem to deal with than a deflationary spiral, which is nearly impossible to break. The problem for the Federal Reserve is that -- while these liquidity programs have inflated asset markets and increased inflationary pressures on the consumer via higher food and energy costs -- they have done little to spur actual organic economic growth.

Today, as the economy weakens, the Eurozone crisis intensifies and the market slides, there have been resurging calls for the Federal Reserve to act with more stimulative measures. Wall Street is salivating at the idea of another round of "Q.E. Crack" to satiate their addiction, while Main Street only suffers.

Bernanke is well aware of the risks that he faces by injecting further rounds of liquidity into the financial markets. The negative impact on Main Street America caused by increasing inflationary pressures, as well as the diminishing rate of return that each program has received in terms of economic growth, is a concern for the Federal Reserve. Bernanke has been tight lipped about further action in recent statements, but in testimony he continues to reiterate that further stimulative actions are possible. He further stresses the importance for Washington and Congress to take action to get the economy growing. However, those pleas fall onto variously deaf, stubborn and divided ears.

The chart shows the effect of stimulative measures on the market and inflation as represented by our inflation composite index. During periods of stimulative action the markets have responded by moving higher along with inflationary pressures. The reverse has been true as liquidity is withdrawn from the markets as the programs conclude. Currently, we are in a period where liquidity is being removed from the market as "Operation Twist" concludes. Not surprisingly the markets have run into trouble as deflationary pressures resurface. However, it is not just the threat of deflation that worries the Federal Reserve.

The U.S. dollar is also negatively affected by these stimulative programs. As dollars flood into the equity markets, the value has fallen sharply. The direction of the U.S. Dollar has a very high negative correlation to the stock market as shown in the chart. One thing to note is that "Operation Twist" had much less effect on the markets and the dollar as compared to the outright balance sheet expansion programs of QE.

For the Federal Reserve the collapsing dollar value, while good for Wall Street, is bad for Main Street as it creates the inflationary pressures of higher costs of food, energy and living costs for the average American. Given that the median U.S. income level has declined over the last twelve years, the decline in economic prosperity has now reached dangerously low levels.

The decline in economic strength has been a conundrum for the Federal Reserve and the Administration. The original intent of the QE programs was to decrease interest rates to support the housing market and to stimulate growth. Lower interest rates should create borrowing and ultimately more economic activity. That turned out not to be the case because the economic weakness has been far more pervasive than realized.

For Bernanke the recent historic lows on the 10-year treasury give him room to maneuver. While balance sheet expansion programs, as shown in the chart, have tended to increase interest rates, any increase in rates from these extremely low levels is likely to be somewhat contained at a more manageable level.

With the dollar stronger, inflationary pressures down and interest rates at record lows, Bernanke can launch a stimulative action program to expand the Federal Reserve's balance sheet and inject liquidity into the market. This is a very likely course of action and something that we discussed back in May, when we stated "There is currently little question that the Fed will intervene at some point soon with QE 3 as there is little evidence that any assistance will be coming to support the economy."

Since that time more signs of economic weakness and deflationary pressures have emerged, applying more pressure on the Fed to take action. However, I do not think that we will see any action before the August-September period which we laid out in our recent PPI report: "While there are many calls for Bernanke to announce QE at the June FOMC meeting, while possible, I think this is a fairly low probability event. Bernanke will likely wait to get a final read on first quarter GDP with some early diagnosis on 2nd quarter as well. With inflation taming, and the markets not absolutely collapsing at this point, my best guess is that he may hint at QE at the next meeting to gauge market response. As QE programs are highly inflationary he will likely wait until the end of summer, with a possibility of post-election, to announce the next round of stimulative action. Make no mistake - there is no real organic growth occurring in the economy and no support coming from Washington. There will be further stimulative programs in the future — it is only a question of when."