Don't Uncork the Champagne Just Yet

By omitting a few key words from their most recent statement, the Fed led Wall Street to the premature conclusion that the next move in interest rates will be down. With the economy clearly headed for recession, there is no doubt that the Fed would like nothing more than to do just that. However, given that it wants to pretend otherwise, and considering the damage it would do to the already shaky U.S. dollar, an actually rate cut seems highly suspect.

Rather than offering a true assessment of the current economy, the official statement that follows Fed meetings has become a political farce used primarily to placate markets. For the bond market and the dollar, the Fed pretends that inflation is still under control, and that the Fed remains poised to snuff out any inflationary sparks should they appear. For Wall Street, the housing markets, and the economy in general, the Fed pretends that the economic expansion will continue, but shows mild concern that growth might falter.

If the Fed were to admit that the economy was in trouble, the stock market would sell off, led lower by a collapse in the dollar and a potential spike in long-term interest rates. With its parsed language, the Fed preserves the pretense that all is well while simultaneously allowing for the possibility of future easing. So by validating the goldilocks scenario, but holding the door open to future rate cuts, they can have their cake and eat it too.

One of the biggest bones the Fed threw to the markets in its last statement was its failure to directly mention the problems developing in the mortgage market. This omission suggests that the Fed is not overly concerned with the subprime crisis, or the possibility of that weakness spreading into the broader mortgage market or the economy in general. In other words, a problem isn't a problem until the Fed says it is. This ignores the fact that the Fed is reluctant to actually identify a problem, no matter how severe; for fear that such recognition alone might spark an even greater panic.

So with the apparent blessing of the Fed, Wall Street can now borrow a page from the Las Vegas promotional playbook and claim that "what happens in sub-prime stays in sub-prime." Unfortunately, like an out of work showgirl with a folder full of embarrassing photos, the problems with subprime will soon show up on everyone's doorstep.

Think of the Fed as a juggler trying to keep five balls in the air simultaneously. Those balls are the stock market, the bond market, the dollar, the housing market, and the economy. If the Fed tells the truth, all the balls will come crashing down. So it says what it needs to say to keep them all in play. However, my guess is the first ball to fall will be the dollar, which sold off immediately following the release of the Fed's statement. Compounding the problem is a recent report that China may no longer be willing to expand its foreign exchange reserves. This means the dollar ball is about to get a lot heavier. Once the dollar breaks down the bond market ball will be that much more difficult to keep aloft. Once it falls, the rest will soon follow.

The bottom line is that waiting for the next rate cut is going to be a lot like waiting for Godot. The Fed wants everyone to think one is coming, but will likely never deliver the goods. If I am wrong and the Fed actually does cut, expect the easing cycle to be extremely short-lived, as an embarrassed Fed will be forced by the bond and currency markets to quickly reverse course.

Wall Street mistakenly believes that the Fed's job is to keep the expansion going. In reality, the Fed's job is to take the punch bowl away from spendthrift American consumers and the leveraged speculators lending them money. If the Fed were to actually do its job, they would accelerate the onset of the inevitable recession. Perpetuating a phony expansion only compounds the problems that a recession would help solve. However, by repeatedly spiking the punch bowl rather than removing it, the Fed merely guarantees a much bigger hang-over when it inevitably runs dry.

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