Tuesday, October 30, 2007

Tough Decision for the Fed

Today is the much anticipated release of the Federal Open Market Committee minutes. This is an exceptionally difficult decision for the Fed. The market has already discounted another quarter point decline in the fed funds rate, so even if they do drop the rate the market may sell off anyway. Neither the market nor the economy got much of a boost from the September rate cut, so what exactly could they hope to gain from a smaller cut a month later? On the other hand of they don't cut, the market will certainly fall out of bed. What's a Fed Governor to do?

Meanwhile the dollar has been looking more like the yen...down, down, down. The entire world is getting very nervous about the dollar and it won't take much more downside to ignite an all out dollar panic. The bond market has been rallying into this anticipated rate cut, but eventually the bond market is going to start discounting the inflationary impact of these rate cuts, which will cut the legs out from under the market and the economy.

As for today, I am betting that the Fed will not cut the fed funds rate. There is too little to gain from a small cut and big risk on the dollar front with a bigger cut. Holding firm will generate a sharp move down in the stock market, especially in financial stocks, but probably not a bear market. Holding firm will also stabilize the dollar and maybe even generate a dollar rally. Overall the Fed gains credibility by holding firm and buys time to try to work out the credit mess.

Update: Well, the Fed cut the rate by a quarter point. As expected the dollar and bonds dropped sharply. Stocks finished higher after an initial plunge and gold rallied to close just below $800. Notable: Bill Gross stated that another full point reduction will be needed to relax tightening credit conditions. The Fed may be contemplating just that, in increments. The bond market will not like that much. I don't think there is any way out of this that is not painful. Inflation here we come.

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