The U.S. Federal Reserve's huge quantitative easing programs are just a continuation of the government's bailout on an unprecedented scale. The fact that it is all presented as part of the Fed's official mandate to promote employment in the context of (undefined) price stability should fool no one. But it does. Markets apparently believe that the unemployment target of 6.5 percent is the loadstar to the Fed's monetary policy.
Markets' apparent belief? Yes, otherwise the bond market would be sinking. But it isn't: the yield on the 10-year Treasury note remains below the 2 percent inflation rate.
(Read More: Fed Throws Junk Bond Lifeline to Weak Companies)
All that makes it possible for the Fed to finance the government's soaring debt at rock-bottom prices.
America's Big, and Growing, Fiscal Problem
To take the full measure of fiscal difficulties facing the U.S., you don't necessarily have to go as far as James Baker, the only person to have managed five presidential campaigns and to have served as the Secretary of the Treasury and Secretary of State. Here is what he says: the U.S. is a Greece without the dollar. In other words, a bankrupt state, but lucky enough to be able to write its own checks in a currency the rest of the world accepts as a means of transaction and a store of value.
This year's U.S. budget deficit is expected to shrink to slightly below 6 percent of the gross domestic product (GDP) from 7 percent last year. But the U.S. gross public debt is not shrinking: it is estimated to exceed 110 percent of GDP by the end of this year - double what it was 10 years ago.
And things will get worse. The nonpartisan Congressional Budget Office (CBO) is warning that budget deficits and public debt will continue to widen as a result of "an aging population, rising healthcare costs, an expansion of federal subsidies for health insurance, and growing interest payments on federal debt."
Just to stop the growth of public debt, the U.S. would have to begin running a budget surplus before interest charges on outstanding debt (technically called primary budget balances), as was the case in the second half of 1990s. We are nowhere close to that: at the moment, that particular measure of the budget shows a deficit between 3 and 4 percent of GDP.
Gathering Inflation Pressures
By monetizing nearly half of government debt issues over the last four years, and bringing the U.S. economy out of recession, the Fed has made a great contribution toward lower budget deficits. Its abundant and cheap credit supplies have also kept interest charges on public debt since 2009 at less than 2 percent of GDP, despite the fact that, over the same period, the net debt-to-GDP ratio increased by 30 percent. That is a big patch on Uncle Sam's gaping fiscal holes.
But all that is nearing an end for several reasons.
First, the economy is showing a sustained and broad-based upswing. The service sector activity (about 90 percent of the economy) is expanding at the fastest pace in the last 12 months, and so are the goods producing industries. Order backlogs are sharply up in both sectors. Construction business, a forward looking indicator, is on a sustained upward trend.
Clearly, the Fed-driven economy is now moving on its own steam.
Second, the headline and core inflation rates at 2 percent look relatively benign, but that will not be the case at higher activity levels. Service sector inflation is currently running at an annual rate of 3 percent.
More important, unit labor costs are pushing up. After an average 0.4 percent growth over the last three years, unit labor costs in the fourth quarter rose nearly 3 percent from the year before as nonfarm productivity sagged and labor compensation increased at the fastest pace in more than a year.
(Read More: Is Fed Signaling Stance on Bank Break-Ups?)
Third, with the Fed's monetary base at $2.9 trillion, three-and-a-half times what it was during the pre-crisis period in the middle of 2008, and banks' excess reserves (at $1.6 trillion) more than 800 times their amount at that time, it is obvious that the unwinding of this extraordinary monetary stimulus is long overdue.
But the Fed will have to be pushed by the markets, because it keeps adding oil to fire: the monetary base continues to grow strongly, and the effective federal funds rate at 0.16 percent is significantly below its 0.25 percent target.
The strengthening economy, underlying cost and price pressures and the huge excess liquidity suggest that markets will soon force the Fed to begin a long overdue withdrawal of an unprecedented monetary stimulus. That will also withdraw the Fed's enormous help to the fiscal consolidation process. The Congress and the White House will have to try harder to find an acceptable compromise.
(Read More: Oil Bulls Bank on Fed to Fuel Rally: Survey)
Assuming (implausibly) that the current inflation rate (2 percent) remains constant for some time, the effective federal funds rate would have to be raised to between 3 and 4 percent – from the present 0.16 percent -- just to make the monetary policy neutral (i.e., neither tight nor loose). That means that in a very likely case of accelerating inflation, federal funds rate would have to go up much higher than that.
Investment strategy implications stated in my earlier posts remain unchanged. Fixed income markets will experience large losses. Equities will also come off their recent highs, because expectations of Fed's policy tightening are already weakening the underpinnings to stock market valuations.
Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia Business School.