-- Posted Tuesday, 25 September 2007 | Digg This Article | Source: GoldSeek.com

Below is an extract from a commentary originally posted at www.speculative-investor.com on 23^rd September 2007.
 
The reason we expected the Fed to cut its targeted interest rate by 0.25%, rather than the 0.50% that it actually decided upon, was the potential for a 0.50% cut to precipitate the events that we have seen over the past four trading days: upside breakouts in key commodities (gold and oil) and a sell-off in the Treasury market. Bernanke and Co. were obviously under a lot of pressure to do something to create some liquidity in the debt market, but by moving so forcefully at the beginning of their rate-cutting campaign they have re-kindled some inflation fires without actually doing much to help the sectors of the economy that are in crisis mode. 

In fact, they may have created even bigger problems for the housing sector and the mortgage-related debt market -- the two parts of the financial world that are hurting the most at this time. This is because their aggressive reduction in the overnight lending rate has caused LONG-TERM interest rates to move HIGHER due to rising inflation expectations, thus potentially making things MORE difficult for a lot of mortgagors and the banks/investors that own huge piles of mortgage-related debt. Furthermore, due to the heightened inflation fears -- or heightened inflation-related enthusiasm, as the case may be -- fueled by their "shock and awe" tactics the Feds now have a lot less flexibility. In particular, they will find it almost impossible to make another cut in the near future in response to a worsening of the debt crisis if the gold price keeps pushing upward and the Treasury market keeps sinking.

This past week's events have constituted a marked deviation from the 1998 pattern we've discussed in recent commentaries. Specifically, in September of 1998 the Fed began its campaign with a 0.25% cut and the financial world's immediate response was "that's not enough!" And in September of 1998 the Treasury market was rocketing upward (bond yields were plummeting), giving the Fed the freedom to make whatever rate cuts it deemed necessary to restore liquidity to the debt market. However, when the Fed opened its most recent rate-cutting campaign with a larger-than-expected 0.50% move the financial world's immediate response was "the Fed is going to inflate the dollar into oblivion!" This was the correct response, although the dollar will not be traveling solo along the road to oblivion because the ECB, the Bank of England and all the other central banks of the world are already taking, or will soon be taking, similar steps.

Fortunately for the Fed, the gold price is very overbought on a short-term basis and the oil market is now close to its seasonal peak. As a result, the gold price is likely to pull back over the coming weeks and the oil price could be near an intermediate-term peak. Also, the stock market looks set to decline over the next few weeks. We say "fortunately" because if these things happen then inflation fears should subside, at least momentarily, thus allowing the bond market to rebound and providing much-needed cover for the Fed to make another cut in its targeted short-term interest rate. There is obviously a risk, though, that the markets will 'turn the screws' on the Fed by continuing to push relentlessly in their current directions. If this happens then Bernanke and his cohorts may want to retract their recent interest rate changes, but will they be able to do so if, in the interim, the debt/housing crisis has become worse?

This is the sort of dilemma a government price fixer will always end up facing, and deservedly so.

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-- Posted Tuesday, 25 September 2007 | Digg This Article | Source: GoldSeek.com

Regular financial market forecasts and analyses are provided at our web site. We aren’t offering a free trial subscription at this time, but free samples of our work (excerpts from our regular commentaries) can be viewed at: http://www.speculative-investor.com/new/freesamples.html

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