This afternoon, after two days of deliberations the Federal Open Market Committee (FOMC) announced a cut of 0.25 percent in its key target rate, bringing it down to 4.50 percent. They also cut the discount rate by 25 basis points.
In its accompanying Statement, the FOMC pointed to their concern at the rise in energy and commodity prices. They also indicated their view that the risks of inflation and recession were now roughly in balance.
If this is so, why the rate cut? Was the Fed forced by the market?
Regardless, I feel that the FOMC action represents a wish by the Fed to pause in its current round of rate cuts—that is, unless more clearly bad news about the economy comes forward.
In a sense, today's rate cut appears as a holding operation, in the hope that things will improve. Sadly, I doubt they will.
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Since late last year, I have said that our economy will move from retraction to recession in late 2007 and in early 2008.
I suspect that the second-quarter 2008 figures will show that we moved into recession at the turn of the year.
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Some of our readers may question why our Fed cut its key rate when there was some good economic news out today? It is an interesting question.
In brief, the reason is that the good news on exports, commercial real estate and consumer spending is not sustainable in the medium term.
However, today's additional shot of financial morphine of a 0.25 percent target rate cut was largely expected and priced into the financial markets. But is it enough?
Our economy is heading for recession. Historically, the Fed is slow to react with a remedial rate cut and usually behind the curve.
History also shows that, depending upon variables — such as the absolute level of interest rates, expectations of inflation and the current position in the economic cycle —interest rate moves by the Fed usually take somewhere between nine months and two years to gain traction in the real economy.
So what are the likely effects of this Fed cut?
Three main areas are affected. They are economic growth, inflation, and the U.S. dollar.
The Fed rate cut will doubtless serve to lessen an approaching recession, but will likely show its effect only 12 to 18 months from now.
On the negative side, the Fed cut will raise inflation and, perhaps more importantly, increase inflationary "expectations," a key element in wage negotiations and "cost plus" inflationary pressures.
An increase in inflation expectations will also lead to a steeper yield curve and a further weakening of the U.S. dollar from its historic lows.
An increase in inflationary pressures will also, as I have long warned, invite the specter of stagflation.
We have to remember that our dollar is not just "our" domestic currency. It is still the main reserve currency of the world. As such, it is a key component of the continued faith in paper money, which is the heart of the world's financial and economic base.
A threat to the credibility of paper currency would be a financial and economic catastrophe for the world.
[Editor's Note:Will the Liquidity Crisis Sink Your Stocks? 12 Ways to Profit.]
Two weeks ago, I attended the World Bank and International Monetary Fund annual meetings in Washington.
On the surface, it was mostly smiles all around as the "cheerleaders" encouraged their compatriots with analyses that showed a booming world economy and the "democratization" of the World Bank, IMF and the International Bank for Reconstruction and Development (IBRD) — the so-called Bretton Woods partners, dominated by America.
In private, however, grave concern was expressed, often in a near whisper, at the subprime credit problem and the implications of a U.S. dollar in free-fall.
On this last subject, I asked Alan Greenspan, our former Federal Reserve Chairman, "whether a continued fall in the U.S. dollar would soon threaten the very viability of paper money."
Greenspan blanched. Then he said, "Things have changed since 1931!"
He then went on to explain how he felt that our trade imbalances were not as damaging as they appear at first sight.
Understandably, it appears that politicians and central bankers, including former central bankers, face a political and moral obligation to maintain national and market morale, particularly in the face of adversity.
In summary, I feel that the Fed Rate cut of 0.25 percent will be good for our economy in 2009.
However, it will not solve the credit problem and will increase the inflationary expectations that are crucial to future "cost-plus" inflation, in the near future of 2008.
At the same time, it will add downward pressure on our U.S. dollar and, most seriously, could begin to imperil the very viability of paper money, creating a serious decline in world trade and leading other countries to follow America in a round of competitive devaluations — the very thing over which Congress is castigating China.
In the meantime, the Fed rate cut will act as a new shot of morphine to stock markets and only add to the disconnect between the hype of Wall Street and the reality of Main Street.
I continue with my 2007 recommendation to our conservative readers to increase, yet further, their weighting in cash, short-term Treasuries, agricultural commodities and gold.
Editor's note:
Bernanke Reveals `Fiscal Crisis` Ahead
Will the Liquidity Crisis Sink Your Stocks? 12 Ways to Profit.
Exclusive: Stocks to Buy . . . and to Dump in 2007.
Commodities Are Still in a Bull Market. Get Our Top 6 Recos for the Coming Year.
