Why the Fed is Likely to Sit Tight Today

Expect the Fed to not cut or increase rates today, as it indicates that inflation is a bigger concern than recession. Though market watchers expected a hike in rates to stop inflation, a hike would be an extraordinary move in advance of the US presidential election.

What this means is the economy will continue to muddle along for at least the next year or so, with flat to middling economic growth rates at best, as the Fed continues its agonizingly difficult task navigating the economy past the Scylla and Charybdis of inflation and recession.

And what this means is many market watchers got it wrong.

Did anyone in government give passing thought last August, after the Bear Stearns hedge funds blew up and the Fed opened the taps with a gusher of liquidity, that inflation would come bearing down like a freight train?

Was there an unspoken plan back then between the administration and the Federal Reserve that the central bank would open the money taps here to save the financials, and in turn administration officials would then travel to the Mideast and jawbone Saudi Arabia to open its oil spigots, to help avoid US inflation?

Instead, the US got promises of a tablespoon of increased daily oil productivity amounting to 9.7 mn barrels a day by July from 9mn currently, an amount that easily dissolves in a world that consumes 86 mn barrels of oil a day.

And with the plunging dollar and the haymaker of inflation due to oil price spikes cutting into profits--half the jump in FedEx's operating costs recently was due to oil price increases--the self-appointed intelligentsia of the markets, the pundits who said a weak dollar would stop the economy from tipping over as it helps multinationals reap more overseas sales, don't look so prescient after all.

Notably because oil price spikes are hurting economies struggling with rising inflation around the world, from Europe to Asia to the Middle East. These are the same countries that take the bulk of America's exports, a sweet spot in the US economy.

And now, despite the most rapid Fed rate cuts in a generation, the financial sector must battle to continue to chop back its dodgy asset-backed securities propped up by all sorts of bad consumer loans, from mortgages to credit cards, securities Wall Street concocted that, on closer look, really are cut and paste jobs creating a drunken daisy chain of bad securities now sitting as landfill in investment portfolios extending to Australia, Asia, Europe, Scandinavian countries and the Arctic.

Frankenstein securities backed by deadbeat loans increasingly defaulting right and left as borrowers bail en masse, dead loans walking. Unloading these illiquid assets in a downmarket is an Olympian task.

Watch Wall Street's bum's rush out the door to the sovereign wealth funds, as the banks desperately seek to revivify their balance sheets. And watch whether the future holds yet another buyer parking its ambulance out in front of yet another Wall Street house to orchestrate another shotgun wedding.

The Federal Reserve has clearly crossed the Rubicon, as economist Ed Yardeni points out, by opening its lending facility to investment banks, a window the Fed had said it would shut by September, though it's expected it will keep it ajar for any emergency.

But watch this move. The Fed is now letting both commercial banks and investment banks swap all sorts of asset-backed bonds backed by dicey collateral for safer Treasurys, bonds that go beyond those propped up by deadbeat mortgages.

The Fed is now taking on potentially more bad paper in the form of bonds backed by student loans, auto loans and credit card debt. The Federal Reserve banks now hold $549 bn in US treasury securities, down from $741 bn at the start of the year, Yardeni says. (Student loans have dried up, not good in a US presidential election year, as investors bolt from these asset-backed securities).

With these moves, guess which bank the government is girding itself for as it might need a rescue, due to its vulnerability beyond mortgages. Citigroup (C)?

And so back to the Fed's statement, due out around 2:15p, when the Fed-parsers, the market Gnostics searching for hidden meaning in Fed chairman Ben Bernanke's every intonation, come out in force. RBS Greenwich Capital, Merrill Lynch and Bank of America got it right.

Watch as the Fed jumps up on a ledge to peer down, far from the muddling, madding crowd (yes, one of my favorite authors is Thomas Hardy, who said "character is fate," how true today).

The Fed won't use language that says inflation risks now exceed the downside growth risks, which would indicate a possible rate hike soon, despite the fact that the Fed's inflation hawks have descended, with two Fed board of governor seats still vacant and the hawkish Fed presidents bringing the overall Fed under their wingspan of influence.

Instead expect the Fed to use language that it is navigating that middle path, as it sits on the twin horns of a dilemma of higher inflation and recession, that it is balancing risks to both economic growth and inflation, as Merrill rightly points out. 

Bank of America, too, says the Fed's "statement will acknowledge a still weak economy and elevated headline inflation, without tipping its hand as to the direction or timing" of its next policy move.

And so the Tinkerbell of hope might be that the economic slowdown will reduce demand for oil and other commodities, bringing inflation down.

The stock market and the economy will come back after the financials stabilize. Which they will after the writedowns end sometime after 2009. And when that happens, so will end the chapter of the "Great and Costly and Crazy Freelance Experiment by Wall Street to Bring 100% Homeownership to America."

And so begins the next bubble: Energy (alternative sources of all stripes) and biotech.

So all of the moves by the Fed and the government to repair the housing mess are laudable, noble and outrageously expensive, but the market in the end will fix itself.

And we will still have to deal with the worst spending bubble of all. The chuckleheads in Congress and the administration who have no more sense than a flock of geese when it comes to using taxpayer money like their own private ATMs.

And so we will have to continue to deal with a government that mindlessly foists on the backs of entrepreneurs, taxpayers and companies the largest budgets in history, as they build their Supersize-Me bureaucracy because they know better than you what's good for you and they know better than you how to use your tax dollars.

That includes using tax dollars to bail out the housing mess.

So inflation pays that tax bill.