The Fed Yields to Wall Street

With yesterday’s announcement of a 50 basis points cut to the federal funds rate, the Fed has officially shifted their expansionary monetary policies to high gear. Their previous move was a hike to 5.25% on June 29th of last year. A month later, when the market was debating whether the next Fed action would be a cut or hike, I stuck my neck out and guessed that an interest rate reduction would be more likely given the drag that the troubled real estate sector would exert on the rest of the economy.

I was wrong about the timing of the cut to the benchmark rate, expecting it to take place much sooner in response to a weakening economy. But the effects from falling home prices and plummeting housing starts have taken a little longer than I thought to filter through the economy. I still expect the economy to stumble into a recession and the Fed to respond with many more rate cuts.

Will it work to keep the recession brief? I am not sure. But I am quite sure that the Fed’s expansionary monetary policies will shake confidence in the US dollar, lead to higher commodity prices, stimulate consumer price inflation, and cause the gold price to exceed $1000 in the not too distant future.

I realize that many people will counter my argument by pointing out that Alan Greenspan printed as much money as all the other Fed governors combined, yet inflationary pressures remained subdued for most of his 19-year term. But that period was marked by the fall of communism and the rise of capitalism across the third world, which allowed production to be shifted to lower cost regions. However, as the recent rise in prices of imports from China indicates, the effect of globalization is receding.

The irony in all of this is that the Fed’s willingness to lower rates and sacrifice the dollar in exchange for economic growth does not address the underlying problem of excessive credit creation, but actually makes it worse by creating a bubble in some other asset class. Perhaps the next bubble will be in gold and commodities.

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