Throughout all last year, I wrote at this blog about the box the Fed is in.  (Read more here, here, here and here).  

Quite simply, the Fed has inflated the money supply beyond all historical boundaries and kept interest rates at historically low levels but banks are not loaning that money out to businesses and consumers. Instead, they are holding the newly printed money as excess reserves, on which the Fed is paying them interest. Consequently, newly printed money that otherwise would be sloshing around the economy bidding up prices is not putting upward pressure on consumer prices.

When the economy begins to revive, however, banks will begin to lend out that flood of liquidity currently damned up on deposit at the Fed. In order to prevent this excessive supply of money from flooding the economy, the Fed will have to drain liquidity before it can escape the banks by raising interest rates and selling securities from its own balance sheet. (When the Fed sells securities it holds on its balance sheet, it withdraws money from the economy in exchange.) Because the Fed’s balance sheet is in such tatters and so bereft of federal securities relative to the amount of “sub-prime” securities it took off the books of the banks, the Fed will not be able to unwind all the newly printed money by simply selling assets off its balance sheet; it will be required to raise interest rates significantly; which will abort any infant economic recovery that might be underway.

In his blog today, Lew Rockwell masterfully explains the trap Ben Bernanke & Co. at the Fed and on Wall Street have walked us into:

“The FED is caught in a trap of its own making. Bernanke cannot figure a way out of it. He promises to unwind, but this is the assurance of the alcoholic that his days of uncontrolled alcoholism are behind him.
“There has been a recent period of monetary sobriety. The FED can reverse this at any time. For as long as it lasts, however, the economy will be faced with deflationary pressures. This is healthy, but not for incumbent politicians. They will demand action on the part of the FED to get the economy moving upward again. All the FED can do at that point is inflate. At some point, it will. But, for now, it has adopted a policy of preliminary unwinding.
“Let us hope that this continues. But let us be realistic: it won't.”