"The Fed is undercapitalized in the way that [Citigroup (NYSE:C)] is undercapitalized, at least before [Citi's] magical transference of preferred to common [shares]."

So says James Grant, the founder and editor of Grant's Interest Rate Observer. That's a pretty disturbing thought when we consider what we know about the bank … and about James Grant. No need to rehash the Citi fiasco; Grant isn't known for making wild pronouncements, and his track record is excellent (he was one of the few people who warned early on about the rising problem of inflated housing and credit markets).

Scary numbers
At the end of 2008, the Federal Reserve had $42 billion in capital for 2.23 trillion in assets, for a capital ratio of 1.9%. The following table shows the capital ratio for seven of the largest U.S. banks:

Bank

Total Capital Ratio (latest quarter)

Goldman Sachs (NYSE:GS)

19.5%

Morgan Stanley (NYSE:MS)

18.2%

Citigroup

15.6%

JPMorgan Chase (NYSE:JPM)

15.2%

U.S. Bancorp (NYSE:USB)

14.4%

Bank of America (NYSE:BAC)

14.0%

Wells Fargo (NYSE:WFC)

12.3%

Source: Capital IQ, a division of Standard and Poor's.

In truth, using the same ratio to evaluate a central bank is misleading; nonetheless, with a balance sheet that more than doubled in size in 2008, the Fed is creating unprecedented risks.

The specter of hyperinflation
A major concern for investors is that printing money at this rate will produce hyperinflation. Central bankers assert that they'll be able to nail the timing for "stuffing the genie back in the box" (i.e. shrinking the Fed's balance sheet before rampant inflation takes hold). Unfortunately, their recent record isn't confidence-inspiring.

After all, these are the same bankers who were seemingly unable to spot two of the largest asset bubbles in history: the Internet stock bubble and the housing/credit bubble. In fact, the Fed was so far off the mark in the latter episode, it fanned the flames of the credit bubble with artificially low interest rates.

Some guidelines for investors
High inflation eats into a bond's fixed interest payments. Conversely, a rising dividend is an effective hedge against inflation. Finally, although I'm not usually a big fan of gold, I think conditions are coming together for this commodity to outperform equities over the next three to five years.

Confused by this market? Ilan Moscovitz weighs in on "The Best Stocks to Buy in This Market."

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Alex Dumortier, CFA, has a beneficial interest in Wells Fargo, but not in any of the other companies mentioned in this article. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.