NEWS / Foreign Exchange

Wall Street continues to dance to the tune of the Federal Reserve

Wall Street continues to dance to the tune of the Federal Reserve by parsing every word that anyone from the Fed utters.

At the slightest hint of a possible easing the stock market goes on a tear. For example, on March 21st, Wall Street thought they heard that the Central Bank might lower rates because of a "slowing economy". But the minutes released yesterday showed the Fed was remaining steadfast in its vigilance against inflation. The exact quote was, "all members agreed the statement should indicate that the committee??™s predominant policy concern remains the risk that inflation will fail to moderate as expected". What amazes us the most is the fact that the market moves up and down (mostly up) on almost every statement made while it has to be obvious that there is a two pronged dilemma that will only be resolved by future statistical data.

You would have to be from another planet not to understand that the economy is in trouble. We have been talking about the housing problem for the past few years. Now, it is clear that the sub prime problem is spreading, and with the more restrictive lending policies, the demand side of housing is collapsing while the supply side (homes for sale) is continuing to increase. Recently, even the National Association of Realtors (who have been absurdly positive until yesterday) just caved in and is now predicting a decline in median home prices this year. The housing related problems, along with the leading indicator index rolling over for the past year, negative savings rate, and high energy cost point to a major slowdown or recession in the economy. Could the Fed raise rates now? At the same time the Fed??™s target rate for inflation is 1-2% and every inflation metric is above the high end of the target range. And with commodities, gold, and a weakening US dollar all pointing to higher inflation it is difficult to imagine a reduction in the Fed Funds rate.

Now, isn??™t it clear that investors should just evaluate the two sides of the Fed??™s dilemma and monitor the economic data to determine which side is the more problematic rather than trying to get some indication from someone (anyone) that is remotely connected to the Fed to determine what they would do? Why don??™t investors try to understand what the Federal Open Market Committee could possibly do by putting themselves in their shoes? What could they possibly do when they are in a complete BOX? What would you do? Can you imagine cutting interest rates with the potential inflationary environment that could result? What would that do to their credibility? How can any reasonable person consider lowering rates with the inflation rates presently above the Fed??™s targets?

On the other hand, how can any reasonable person consider raising rates into the decelerating economy exacerbated by the housing problems? Some pundits seem to think that as long as the employment numbers are hanging in there, that the economy could still have a soft landing. We have tried to point out in many of our comments that the employment gains we have witnessed since the trough of the economy is less than ?? the average employment gains in every recession recovery since World War II. Could you consider raising rates right now if you were on the Federal Open Market Committee?

What this all says is that the Fed is in a BOX and that they have to keep the Fed Funds unchanged unless some future economic data come out that would force their hand one way or the other. What future data could possibly be released that would make the "goldilocks" economy thrive? The only data that would be positive for the market is for the economy to slow down without going into a recession while the inflation gauges slow down. This scenario would allow reasonable people to start lowering rates. However, this is the only scenario that would be positive. If, on the other hand, the economy slips into a recession, or if inflation continues to rise, the stock market would probably decline regardless of what the Fed did. The worst case would be if inflation continued rising and the economy continued to slow. This is the "stagflation" scenario that would be the worst condition possible for the stock market.