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The Bernanke Bet

Author: Bob Lang (info)
Website: http://trade-mentor.com
Posted: September 19th, 2007 at 12:18 pm EST
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As we expected, the Fed was very aggressive with the funds rate on Tuesday and lowered the Fed Fund and Discount Rate 50bps. There is a likelihood of more cuts down the road, but perhaps not with the same crushing blow. We see Fed Funds possibly dropping to 4% before they are finished. Ysterday’s market reaction was certainly a pleasant surprise, but what is the Fed’s thinking behind this move and further, what are do they see happening down the road?

With the first rate cut in three years, the Fed has put the world on notice that they care about growth NOW, and will worry about inflation LATER. A big rate cut or series of cuts will instill confidence in the consumer and allow the banks to get back to how they do business…lend money. Easier credit will knock out the fears from the recent credit crunch and help to stimulate an economy that is driven 2/3 by the consumer. But won’t easy credit, massive liquidity and lower rates stoke inflation? Answer, yes and no.

How can increased funding not produce inflation? Afterall, too many dollars chasing too few goods drives prices higher and can create a bad inflationary problem. However…a strong economy supported by higher productivity can sustain growth that is not inflationary…if the growth is moderate. Get the economy growing again in the 2.5-3% range with higher worker productivity gains and you are back to a Goldilocks scenario (not too hot, not too cold). Bernanke felt comfortable cutting yesterday because of the lower trending price inflation and the slack that will be coming in the currently tight labor market. Without the mortgage and housing crisis, the Fed would have probably cut anyhow (smaller).

For the near term, markets will have the wind at their backs. Remember the old adage, ‘don’t fight the fed’. It’s resonating loud and clear with the markets. Once confidence returns, momentum can be a one way train that you don’t want to get in front of.

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