One Can Only Hope

Here's a piece that says the Fed's game is not creating inflation, but managing the inevitable deflation.

excerpt:

But suddenly it appears that the Fed is concerned about inflation. From yesterday's statement:

Inflation has been elevated, and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook has increased. It will be necessary to continue to monitor inflation developments carefully.

While it isn't explicitly talking about doing anything, the Fed is telegraphing its concern about too much inflation. This is one of several clues that the Fed's next task will be to tackle the inflation problem. Another clue is that the Fed didn't lower rates the full 100 basis points that the market was expecting. Third, the Fed's myriad new "lending facilities" are addressed at liquidity, and are not inflationary, as this insightful piece shows. If the Fed were to start buying banks' subprime securities outright, that would be inflationary. The banks would have a reload of free money. But this way, the lending facilities are forcing banks to keep ownership of their rotten securities, and allowing them to write them down slowly over time. This is deflationary, but the Fed is attempting to create an orderly deflation.

Why deflate? There is simply too much debt in the system. I don't believe the Fed is stupid enough to believe that it can inflate forever. The dollar is at risk, and the dollar is the source of the Fed's and America's power. If we lose that, all is lost. The Fed's most important task must shift to saving the dollar by presiding over a managed deflation, economy be damned.

And lest you think that Wall Street banks will take their new found borrowings from the Fed's new lending facilities to go out and leverage up and party on like the old days, think again. The Fed has sent a loud and clear message with Sunday's ritual sacrifice of Bear Stearns.

That's right - ritual sacrifice. The Fed could have easily saved Bear if it had just given it access to borrow at the discount window. Investment banks have that access now, but poor Bear couldn't get the cash last week. Instead the Fed let JP Morgan eat Bear for dinner, in a shocking, brutal and bloody ceremony. The Fed even picked up the tab. Like all ritual sacrifices, the choice of the victim was random. It could have been any one of the banks on Wall Street. Confidence was crumbling across the board but it just happened to be that the bank run started at Bear Stearns. The purpose of the ceremony was to scare the crap out of all those watching. It was a display of Fed power both to the world and the rest of the banks on the street. To the world it was a statement that the Fed will protect the system. To the banks, it was a stark warning from the Godfather: "Forget moral hazard. If you f*ck up, you will be left with nothing. Do you understand me? Nothing!" Enough of the funny business that got Bear into trouble - everyone has to clean up their act, lest they too end up like the poor employees of Bear Stearns.

But this is highly deflationary. It means that banks, fearing for their very existence, have to cut back on all the crazy strategies of 100:1 leverage, exotic derivatives, etc. The Fed won't bail them out. But without all that funny leverage, how can markets keep going up? Answer: They can't, and I think today the market realized that. Across the board everything was down: Commodities crater as economic worries take hand

Oil futures lost 4.5% to end at $104.48 a barrel on the New York Mercantile Exchange, its biggest daily loss since 1991. Gold for April delivery, which hit a record high of $1,034 an ounce Monday, plunged $59, or 5.9%, to finish at $945.30 an ounce, its biggest one-day drop since June of 2006. Wheat futures lost 7.7% to trade at $10.74 a bushel.

But surprise, surprise, surprise. The dollar finally had a little rally. Obviously one day does not a trend make. However, if the Fed is serious about restraining inflation, it has a very tight rope to walk. In this super leveraged world, just a tap on the inflation brake could send markets spiraling into a deflationary collapse. The Fed has got a huge challenge on its hands, managing an orderly deflation.

Market watchers take note. If deflation is beginning to spread beyond the housing market, we should start to see it reflected in the Dow soon.

If there is anything remotely honest and rational about the world, I'd expect to see the parabolic commodity boom crash, as well as the stock market. There is simply no way that we can have a 12,000 DOW, $1,000 gold, $100 oil, and T-bills at 0.6%. This rubber band has got to snap, and soon.