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Dance! Dance! Dance!



Now that the Fed has issued its latest from the Mount, over the next few weeks and months expect a gaggle of economists, strategists and Fed officials to limn the details of today's missive. Trotted out will be the idea that the Fed will be able to engineer a smooth transition in interest rate regime: from accommodative to neutral.

You already know our feelings on the Fed's desire to micromanage the economy: it creates serious unintended consequences. 12 economists deciding what the cost of capital should be and fiddling with short term rates to get there cannot possibly be smarter than the market itself.

When stocks, commodities, real estate, and corporate bonds were all surging in the last 18 months or so, no one cared much about their positive correlation. After all, folks were making money. That correlation, of course, was and is now driven by the massive liquidity created by historically low rates.

But few are talking about the downside of that positive correlation now that the Fed is starting to think about becoming less accommodative. John Succo spoke about it in his article above, but outside of us worry-warts, the idea that previously uncorrelated assets could see a material decline has alarmed no one. And taking away some of the liquidity that has been ever present in the system these last 18 months cannot be done without some serious potential dislocations in the financial firmament. It will only be a matter of months (perhaps quarters) when we'll see which financial intermediaries have been playing fast and loose with the Fed's largesse. The old saying that every credit cycle ends with the biggest creditor going bankrupt is an apt saying now that the Fed (and the market) is suggesting the liquidity party is over.

Few debate the idea that this economy is driven by asset prices. And if assets start to fall they can have a self-reinforcing effect, just as they did on the way up over the last 18 months. This is the unintended consequence that is created when you try to manage the largest economy in the world.

It'll sure be fun watching the Fed and its minions dance as they try to convince everyone that they can change the interest rate regime without any undue effects.

Near term fun. Long term tragic.

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