The Fed’s Gone All In

The equity market rebound continued this past week, but just barely.  Although the S&P500 finished up about 1.5%, it was fading badly as the week drew to a close.

Earlier in the week, the momentum from the prior week’s bounce continued to build.  Then the buying sputtered, and the selling returned on Thursday and Friday, mostly after the market reacted to the Fed’s latest FOMC decision.

Fundamentally, signs of hopeful economic data were generally missing.  The Empire manufacturing report and industrial capacity utilization results were the lowest on record.  Industrial production fell more than expected.  Initial claims remained in the mid-600,000 range, pushing the 4 week moving average up to the worst level since 1982.  The one supposedly bright spot–housing starts–wasn’t so bright after all because the spike was driven by a non-recurring jump in apartment construction, not single family homes.  Also, several corporations warned that their most recent outlooks are poor and still deteriorating; among these were FedEx, Nike and Adobe.

Technically, the two week rally is on the verge of breaking down.  Friday’s 2% drop in the S&P pushed most indicators to the limit:  if there’s any more selling early next week, the short-term rally could be over. 

So what did the Fed do, and what are the ramifications?  Simply put, the Fed decided it will print money, a lot more money–over $1 trillion’s worth.  With the fed funds rate at virtually zero and with economic demand still falling dramatically,  the Fed will buy Treasury and agency debt to shovel more dollars into the economy, hoping to drive down interest rates.  The bet is that consumers and corporations will find credit less expensive and more accessible so that they’ll be more likely to buy things, thereby pushing up demand to match supply and prevent deflation.

What’s the problem? 

First, our currency gets debased.  And sure enough, gold priced in dollars soared and the dollar fell in terms of other major currencies like the Yen and the Euro.  Second, and related to the first, is that the risk of inflation goes up.  If the Fed doesn’t mop up the extra dollars when (or if) demand picks up, then inflation may rise.  Inflation may also rise if the demand doesn’t pick up forcing the Fed to print even more dollars because the markets will expect and demand that the Fed do so.  Third, what’s the rest of the world going to think and do?  One risk is that other major economies begin a self defeating race to the bottom by doing the exact same thing;  in fact, the U.K. and even Switzerland have also started their own programs of quantitative easing.  Fourth, as Japan’s experience over the last 10 years has shown, quantitative easing is not likely to work.  It does not and cannot force people and businesses to spend.  Finally, what about the signal effect?  Are things so bad economically that the Fed is willing essentially to bet the house on a low probability move? 

From the looks of it, things are that bad.

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