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Number of posts : 440
Registration date : 2007-07-01

PostSubject: BERNANKE'S BIG TEST IS ABOUT TO BEGIN   Mon Sep 10, 2007 12:05 am

The Capital Spectator

Money, Oil, Economics & the Search for the Bottom Line



September 10, 2007


The Federal Reserve is virtually certain to cut Fed funds rate in
the wake of Friday's news that the economy is shedding jobs for the
first time in four years. But the anticipated easing still comes with

It's not obvious that more liquidity is the solution for what ails
the economy. The return of job losses after four years of gains may
simply be the natural ebb and flow of the business cycle. There's a
general sense that such cycles have been banished to the dustbin of
economic history, but that's a premature conclusion. Yes, the Fed has
learned how to smooth the business cycle with tactical injections of
liquidity. But there's no free lunch and it's possible that keeping
deep recessions at bay all these years has been a temporary triumph
that's had the unintended effect of letting excesses build up to the
point that they're now set to burst forth.

If the cycle is poised to reassert itself on the downside, the Fed
will no doubt intervene in an effort to keep the economy bubbling. The
past 20 years have shown that the central bank is inclined to do just
that. But at what cost? Has the smoothing of the business cycle in past
years dispatched the fallout or simply rolled it into the future?

The economy may be weakening but the cause doesn't fit neatly into
the classic boom-bust story. In the old days, the Fed would choke off
rising economic growth by raising interest rates, sometimes by too
much. The tightening brought recession, which in turn spurred the Fed
to ease to induce growth once more.

This time, however, it's debatable if the economic slowdown that
appears to be in progress is directly caused by excessive monetary
tightening in the traditional sense. The Fed funds rate has been at
5.25% since June 2006, but the charge that the price of money's been
too high is exaggerated. Only in recent weeks has the cry for lower
rates gained critical mass.

Judging by the 10-year Treasury yield, for instance, interest rates
have been fairly low by historical standards. One reason the 10-year
yield's been relatively low is the surge of liquidity in the global
economy, a large chunk of which has been routinely flowing into the
U.S. The Fed controls the domestic money supply in theory; in practice,
central banks around the world have a growing sway on U.S. liquidity
levels. As you may recall, it was Fed Chairman Bernanke who promoted
the notion a few years back that a savings glut was evident in foreign
economies, notably in Asia. Last we checked, the glut's still intact

Nonetheless, the Fed will probably lower interest rates. But for an
economy that's been swimming in liquidity for several years, arguably
to excess, it remains to be seen if more of the same will induce the
old magic one more time.

Simply put, there are risks to doing nothing and there are risks to
cutting. The conventional wisdom now is that the risks of the holding
rates steady outweigh cutting, and so lowering Fed funds is now a
forgone conclusion when the FOMC meets on September 18. In fact, the futures market expects that Fed funds will fall to 4.50% by the end of this year, 75 basis points below the current 5.25%.

The cause, at least will be clear: the economy seems to be
weakening, or so the August employment report advised. But that doesn't
automatically mean that the excess liquidity that's built up in recent
years has evaporated. Indeed, the inherent conflict between the central
bank's dual mandate of containing inflation and maximizing employment
is especially perilous at this juncture.

That, at least, is one interpretation after witnessing the renewed
rise in the price of gold. An ounce of the precious metal changes hands
at a spot price of $700, the highest in more than a year and up 7% from
a month ago. Some of the surge is directly tied to worries over future
inflation, which may rise if the Fed overshoots on its new adventures
in liquidity injections. M2 money supply is already rising at a healthy
clip--up by 6.3% at an annual rate for the 13 weeks through August 28.
That's up sharply from a 3.7% pace in M2 growth from a year earlier.

In a related concern, the gold market notices that the dollar's
getting weaker, a trend that will accelerate if the Fed drops interest
rates. Gold and the buck historically have shared an inverse
relationship, with each moving in the opposite direction relative to
the other.

The U.S. Dollar Index on Friday slipped below 80. Save for a brief
time in 1992, the U.S. Dollar Index has never traded that low in 35
years. The dollar, in short, is probing new and uncharted depths in the
modern era of free-floating currencies. The Fed can't ignore the fact
that lowering rates will almost surely hasten accelerate the pace of
the dollar's descent, which in turn will embolden the gold bulls. At
the same time, the Fed's under enormous pressure to lower rates to head
off what may be a recession.

This, dear readers, is the monetary rock and the hard place. It's
been a long time coming. Mr. Bernanke, as a result, is facing what
seems likely to be the test that defines him, for good or ill, as a
central banker.
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