The Fed Cannot Save Us!

I said this last week and I will say it again. The current economic problems have gone by the Fed, these problems are passed our first line of defense, they are “inside the wire” (to use an expression from my generation), or whatever other expression you may want to use. The Fed only controls the money supply and they have limited ammunition. With the recent rate cuts, now we are down to 3.75% on the Fed Funds rate. The Fed is almost out of ammunition. They know that. That is why Dr. Bernanke was in the Congress last week giving his stamp of approval to the “stimulus” package. The stimulus package is our last line of defense. What worries me is that there are still problems out there to be faced such as credit debt swaps, more charge-offs in housing as the markets continue to deteriorate, possible corporate debt losses, losses on credit card and auto portfolios, etc. Text in bold is my emphasis. From CNNMoney.com/Fortune:

Forget all those rational explanations about why foreign stocks markets, especially in Asia, have been melting down for two days. Despite what you've read, seen and heard, those declines weren't caused by fears of what a recession in the U.S. would do to the profits of companies whose stocks trade in places like India, China and Russia.

Rather, the meltdowns were flat-out market panics, where rationality gets tossed out the window as everyone tries to head for the door at once and gets trampled. Go-go markets, especially in Asia, had risen to ridiculous heights - they were going up because they were going up, and momentum fed on itself. Now, they're going down because they're going down, and momentum is feeding on itself again.

The fact that the Federal Reserve Board announced an emergency cut of 0.75 percent in short-term rates shows that the Fed thinks the problem is a market panic rather than economic fundamentals. Normally, the Fed would have waited until mid-day next Tuesday - the second day of its scheduled two-day meeting - to announce a rate cut. Announcing an out-of-schedule cut today before the stock market opened shows that its motivation is to calm the markets rather than to reinvigorate the U.S. economy.

Here's why. First, it won't be clear until the summer whether a recession is in fact underway in the U.S. Even though the nation's economy seems likely to have shrunk in December, there's no such thing as a one-month recession. "A recession is a significant decline in economic activity spread across the economy, lasting more than a few months," (my italics) according to the definitive authorities on such things, the business cycle dating committee of the National Bureau of Economic Research.

Second, even if you believe that the Fed's cut in short-term rates will stimulate the economy, that won't happen overnight. If you took a Fed economist out for a few drinks and promised not to quote him, he'd tell you that the benefits of a cut take at least six months to percolate through the economy. There have been market panics and freeze-ups all over the world since last summer, when the junk mortgage meltdown in the U.S. started gathering speed. These have been confined mostly to the debt markets, which - unlike the Dow Industrials - don't resonate with most people and can't be summed up neatly in one familiar number, as the Dow is.

But now there's a panic in the stock markets, where it's visible for all to see. Last year, 41 of the 100 best-performing stocks were from India, according to Russell Indexes. The Shanghai stock market almost doubled.

This makes no sense unless you consider the Indian and Shanghai markets to have been undiscovered before 2007 - which they weren't. Had the Fed not done anything today, the Dow could easily have fallen 600 or 800 points. Instead, it closed down less than 130.

The problem is that the Fed has only a limited amount of rate-cut ammunition, and expended a lot of it today. It's expected by the markets to cut rates again next week, and will have used up most of its bullets.

I don't want to get into the what-should-the-Fed do game - I'm a recovering English major, the Fed is full of brilliant people with doctoral degrees and access to information that I don't have - but I'm growing increasingly uneasy watching short-term rates in the U.S. fall when we're so dependent on foreign money to cover our trade deficit and the U.S. budget deficit.

I'm also less than thrilled watching commodities prices rise, although oil has been drifting down lately. There are already worrying signs that foreigners, who keep score in their home currencies, have grown tired of losing money because the value of the dollar's dropping. Should the dollar's decline turn into a rout, a distinct possibility, things are going to get really messy.

Look. We can't depend on the Fed - or any individual institution - to save us. The Fed isn't all-powerful - and wasn't all-powerful under Alan Greenspan, either. Current Fed Chairman Ben Bernanke doesn't have a magic wand he can wave to make everything all right on both Wall Street and Main Street. He's doing the best he can, but the Fed's influence isn't what it was when financial markets were much smaller than they are now, and far more regulated.

Because of its budget and trade deficits, the U.S. has to worry about what the rest of the world thinks. That's what happens when you're a debtor nation. There are huge risks in cutting short rates, and risks, too, in having Uncle Sam borrow another $150 billion to $200 billion (primarily from foreigners) to finance a short-term stimulus package.

The bottom line: In the long-term, markets are generally rational. In the short term they are...well, markets. They're prone to irrational run-ups and irrational declines. Don't expect them to act the way you want them to. And don't expect the Fed to save you if they don't.