Tuesday, August 07, 2007

Whither the Fed?

The Federal Reserve Open Market Committee meets today and will announce the results of that meeting at 2:15 this afternoon. What should we expect? Well, if you listen to Wall Street, the statement released this afternoon will likely acknowledge the credit market's problems and offer a balanced view of the risks of inflation and economic growth. That would be a major change from the recent statements which have all emphasized inflation as the Fed's major headache.

If Bernanke and Co. follow this path, the market will start to seriously price in a rate cut soon. I think that would be a mistake. The Fed certainly faces a tough balancing act as they try to ensure full employment and low inflation. In the past, the Fed has always erred on the side of full employment and growth rather than low inflation and that is the source of many of our long term economic problems. Alan Greenspan caused this mess by cutting interest rates to generational lows after 9/11 and leaving them there for way too long. Now, in the aftermath of the Fed induced housing bubble, Bernanke faces a no win situation in my opinion. If he cuts rates due to the credit market problems, he will lose any credibility he has built as an inflation fighter. If he doesn't cut rates, a recession becomes that much more likely and he will face major political pressure in an election year. Frankly, I'm not sure he would survive it.

Unfortunately, I agree with the market consensus that the Fed statement will be seen as market friendly and announce that their bias has shifted to neutral. As for whether they will actually cut rates, that may depend on the market's reaction to the statement. I have been watching the Fed for many years though and they have always used easy money as the palliative to the consequences of previous policy errors. I don't expect anything different this time.

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