The Fed issued a convoluted post-meeting statement last week and spent a good part of this week trying to clear it up.  In our comment following the FOMC meeting, we indicated that most of their release was bearish since they raised the level of their inflation concerns while, at the same time expressing more concern about economic growth.  We also criticized their failure to mention subprime lending, leading to the misguided belief that they weren??™t concerned.  That omission together with the dropping of their reference to firmer rates led to a vigorous late-day rally on the assumption that the chances of a rate decrease had taken a giant leap forward.  Interpreting the statement somewhat differently than the Street, we warned that the initial market response to an FOMC statement is not necessarily correct.  In fairness, however, we have to say that for a Fed interested in greater transparency, the statement was quite confusing and subject to various interpretations.

The Fed recognized the problem quickly, and did not even wait for Bernanke??™s Wednesday appearance before Congress to clarify their message.  Tuesday??™s Wall Street Journal carried an article by reporter Greg Ip that was obviously based on an off-the-record conversation with someone at the Fed??”probably Bernanke himself.  In the article Ip made statements about the Fed??™s views that weren??™t previously public, and that he couldn??™t have known without a source inside the central bank.  This is in keeping with previous Fed practice of speaking off the record to selected widely-read financial reporters when trying to correct important misinterpretations of their views by the markets.

In the article Ip states that "The Fed is seeing increased risks to its forecast that the nation??™s economy will grow moderately this year.  Those risks include the surprisingly weak level of business investment and the hard-to-predict outcome of the current troubles at the riskier end of the mortgage market.  The Fed changed its statement last week to get the flexibility to cut interest rates in coming months if those risks grow.  But it is unlikely to use that flexibility anytime soon, because the risks aren??™t big enough and inflation remains uncomfortably high.Fed officials had expected that as the housing market slumped, stronger business investment would pick up for the slack.  But business investment has been surprisingly weak; capital-goods shipments excluding aircraft and defense products have fallen in four of the five months through January.  February data will be released tomorrow.  While officials still believe demand for housing has stabilized, they acknowledge the recent turmoil in the subprime-mortgage market adds an unpredictable element to the outlook for the housing sector."

The WSJ article pretty much sums it up, and the Chairman??™s congressional testimony the following day added little to that summary.  It seems clear that the Fed is stuck between a rock and a hard place.  Economic growth is slower than expected.  The housing mess is likely to spread and capital spending does not show any signs of picking up the slack.  At the same time inflation has not moderated as the Fed expected and they fear cutting rates too soon.  This is the same predicament faced by the Fed in previous cycles, and, in the vast majority of cases, by the time they cut rates it was too late to stave off recession.  In our view the market is making the same mistake as in 2000, when most observers believed that the collapse of the Internet boom would not spread to the rest of the economy or the stock market.  Just substitute "subprime" for "Internet", and we have almost the same situation seven years later.