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Tuesday, December 11, 2007 3:18 PM


Fed Tiptoes Thru The Tulips


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With the December FOMC Statement I sense the Fed does not realize what they are facing in terms of asset and monetary deflation.

Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks. Today’s action, combined with the policy actions taken earlier, should help promote moderate growth over time.

Readings on core inflation have improved modestly this year, but elevated energy and commodity prices, among other factors, may put upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

Recent developments, including the deterioration in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.
The risk of inflation is extremely overstated.
None of the above have remotely anything to do with inflation. Furthermore, given that the Fed cut both the Fed Fund Rate and the Discount Rate by only 25 basis points, the odds are very high that that Libor Spread makes a new high tomorrow.

Fed Almost Gets It Right

Nonetheless I agree 100% with Professor Zucchi who stated:
This one is gonna hurt...

Boom Boom almost did the right thing. Had it spared us the pandering 1/4 point begged for by financial speculators, he would have finally shown the kind of stones that will be needed to guide us out of the current mess. Equities do not like it one bit, as well they shouldn't; the wimpy move is likely to worsen the credit environment and the financial markets as a whole could be in for a year-end pasting. So why do I suggest the Fed did the almost right thing?

Because one cannot devalue its way out of a gigantic pile of debt. Companies, many companies, need to fail, go away forever, and allow those who have a business existing to once again prosper not on the back of borrowed money, but on the strength of real demand, rather than demand generated by a need to circulate make belief money.

Had the Fed figured this out in 2001, by 2003 we would likely have forgotten the then recession. Instead it decided to try to fool everyone into believing that we could borrow our way into a permanent plateau of prosperity.
Professor Zucchi has this correct.

Unfortunately, I expect the Fed to continue to tiptoe through the tulips on the way down, just as they tiptoed to 17 consecutive rate hikes, never willing to end the gravy train of the housing bubble.

I am unwilling to give Bernanke any credit here because I suspect the only reason he is not cutting more aggressively here is to save his surprises for later and/or he simply does not understand the situation at hand. He has already shown a propensity to surprise, with a discount rate cut during options expiry week.

I just just heard Bill Gross quoted on Bloomberg: "The Fed does not understand the gravity of the situation". I agree. But if credit markets continue to act poorly, there will be more surprise discount rate cuts and surprise rate cuts as well. Bernanke does not have "kind of stones" it will take to let the market play out by itself.

The asset deflation train Japanese style has left the station. Bernanke is driving. How long it takes to get to the destination depends in part on how many detours Bernanke takes along the way.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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