Central banks around the world are busy cutting rates, bailing out financial institutions and increasingly looking at the option of quantitative easing. The Federal Reserve is of course the undeniable leader of the pack.

Fearful of the occurrence of a deflationary scenario, the Fed is willing to take strong action to prevent it from becoming a reality. In this regard, their interpretation of Japan's past experience is that you have to move quickly and massively to turn the tide.

Arguably, America's problems are worse than what Japan had to face after its bubble burst. US households entered this recession with very low savings rates, even as their finances are continuing to deteriorate. This, combined with the rickety state of the financial system is enough to give Bernanke the shivers.

Needless to say, those countries with problems similar to the US are also emulating its policies most closely. Across the Atlantic, in the United Kingdom, the old lady of Threadneedle Street is applying an axe to interest rates. The worthies at the Bank of England have cut rates to the lowest level in over 300 years. And the consensus view is that they are ready to go into action again.

Many countries in the Eurozone, such as Ireland, Spain and a number of others may be wishing for a more generous central bank than the ECB. The European Central Bank has been overly cautious in cutting rates, although its hands were forced recently. Still, among the majors, it remains the main candidate to resist a zero interest rate policy for as long as possible.

As we have stated previously, the extraordinary measures that are being implemented by central banks are fraught with risk, and it is necessary to spell out what is at stake. Of course, policymakers may retort, defensively, that not acting to save the banking system and allowing the economy to descend into even deeper recession is costly and politically unacceptable.

That may be the case. All we are saying is that policy overshooting and errors have implications for investment decisions. It is important to understand what sorts of mistakes are being made.

We have a monetary scheme based on fiat money, with a fractional reserve lending system. The reserves of the system are essentially liabilities of the Fed (we are using the American central bank in this example, but the argument applies equally to any other country). Policymakers determine the quantity of reserves and the reserve ratio. Market forces, via lending and borrowing, determine the total quantity of money.

In tough times, such as we are currently experiencing, the money multiplier falls as banks cut back on their lending, and borrowers refrain from taking out loans. In addition, the past year has been witness to significant losses in asset values.

The Fed has reacted by creating substantial growth in bank reserves, but it does not appear that the multiplier is responding in the desired direction. And, normally, policymakers expect monetary expansion to have a knock-on effect on all asset values.

Disappointed with the result, they have brought in quantitative easing, moving to monetise assets directly by printing money and purchasing them. The overall objective of the policies is to counter wealth destruction and restore nominal asset prices, as well as furnish sufficient liquidity to create ongoing demand for these assets.

Once asset prices have appreciated sufficiently to support debt levels, the Fed would attempt to remove the excess liquidity from the system. Anyway, this is the game plan. Obviously, printing money to boost reserves and buy assets is easy to do for any central bank. However, the exit strategy is very difficult indeed.

How does the Fed know if, and when, asset prices have been adequately restored? How do they judge what is the proper amount of liquidity in the system? Unfortunately, the assessment will be imprecise and the timing difficult. Given policymakers' proclivities, they are motivated to err in overachieving rather than falling short of the target.

Ultimately, the banking system will stabilise and demand for credit will begin to increase. At that time, there will be a massive amount of reserves in the system and with the money multiplier increasing back to normal, liquidity will rise substantially. Will the Fed mop up the liquidity feverishly and compromise the nascent recovery?

Iraj Pouyandeh is a strategist and senior portfolio manager at LOM Asset Management. He manages the LOM Global Equity Fund. For more information on LOM Asset Management please visit www.lomam.com