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Of Needles and Fat Men


The Fed, in its desire to micro-manage the economy, has gotten itself into quite a pickle since the last Fed meeting on June 25th. Since then the ten year treasury yield is up 100+ bps, the 2 year note is up 60 bps+, and the dollar is 2% firmer against the Euro. All of this while inflation has actually dropped y/y (50 bps since this January), making the above tightening even more contractionary in real dollar terms.

Certainly this isn't what the Fed wants, as they have gone out of their way to reiterate their last policy statement that rates will stay low for "the foreseeable future." So what's a proactive Fed to do? Two words: jaw bone.

The Fed's statement today will be of particular importance, but not so much for their immediate impact on bonds or stocks this time. Rather, to me it will be important in how the Fed balances itself on the head of this particular pin: generating much-needed confidence among consumers by saying the economy is on the brink of renewed growth while also assuaging the fears of the bond market that the economy isn't growing so fast that they need to sell their bonds, drive yields up, and therefore choke off whatever nascent acceleration is taking place. Consumers and businesses need the animal spirits to take risks and grow the economy. The bond market needs to know we're not on the cusp of a major new expansionary phase in the economy.

Serving two masters. Rock and a hard place. Scylla and Charybdis. You get the point.

A full exploration of the Fed's obligations aren't possible in this forum, but understand that the Fed's main goals are fairly simple: keep the banking system liquid and public confidence in banks high and maintaining the market's confidence in both treasury securities and the US dollar. This particular corner they have painted themselves into is entirely of their own making. They have no legal obligations to micromanage the economy. But that is what they are attempting. Needless to say, financial history is replete with these type of efforts. And, in due course, they all fail. You simply cannot control a complex system to any great degree over any length of time.

How the Fed acts today will be an important harbinger for the future, when today's financial landscape will look absolutely benign in comparison (you know the score: mortgage debt, derivatives, deflation, current account deficit, sinking dollar, bubble work-out, etc). Do they release a statement that soothes opposing forces, trying to fit a fat man through the eye of a needle? Or do they wash their hands of the effort and leave the economy and financial markets to its own Schumpeterian ways?

Lamentably, any knowledgeable bookmaker would take the fat man over Schumpeter 4-1. So will I.
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