Fed 'Chickens Out'
Keeps Rates On Hold -- Inviting Grave Future Problems
MoneyNews.com Editors
May 9, 2007

This afternoon the Fed announced that its key rate will remain unchanged.

In its statement, the Fed pointed to economic growth slowing in the last quarter and a continuing unwinding adjustment in the housing market. In addition, they saw moderate economic growth ahead. However, they also pointed to an elevated rate of core inflation.

In short, the Fed veered very little from its last statement.

It should be remembered that the statement is the Fed Chairman's hidden 'club' that he can wield to ensure unanimity in the vote of his FOMC. One should not read too much into it.

With a confused and 'fearsome' Fed, it is their actions that count, far more than their words. Today, their action was to rely upon the 'cooked' CPI and to take no action.

Stock markets heaved a sigh of relief. We believe that stock markets are likely to continue, what we term as their 'thin-ice,' liquidity-driven leap into the stratosphere.

Bonds sold off slightly.

But what are the future macro economic implications?

Our readers will know that we have long urged an increase in rates, both to curb stealth inflation and to defend the U.S. dollar.

The Fed has disappointed us these past six months.

In our view, the Fed has 'chickened out' yet again and will make conditions far worse in the future as the U.S. dollar continues its downward, inflationary plunge and, what we term, stealth inflation becomes progressively unleashed upon the financial world.

This will eventually cause an increase in rates, but higher rates and in panic rather than the orderly fashion possible if timely action had been taken.

We admit that the Fed is in an un-enviably difficult position -- a cleft stick of major proportions.

With its dual mandate, the Fed has to balance controlling inflation against maintaining economic growth.

As we have said for some time, we feel that the Fed also faces a new mandate -- to defend the U.S. dollar both against a profligate government and against the current wave of anti-inflationary interest hikes by competing central banks, most notably from: the European Union, Great Britain, and Australia.

As our readers will know, the 'real life' inflation that we face as we fill in our tax returns is far, far higher than the 2.1 percent official CPI inflation rate.

We believe that by politically 'cooking' the statistics (by excluding key 'real life' items such as: house, gasoline, and services costs such as health and insurance), our government achieves a CPI that allows them to borrow at far less cost and to pay out billions less in social security payments.

Fortunately, most of the 'manufactured goods' sector that is still included in the CPI has been held down by cheap imports and competition from Asia, most notably from China.

In this respect, we note with concern the 'China bashing' stance of the new Democratic Congress.

If such legislation is passed, it will unleash great upward pressure on the CPI and upon future interest rates. This is especially so as U.S. productivity is slowing.

Some astute commentators, such as Larry Kudlow of CNBC, who knows Fed Chairman Ben Bernanke personally, say that he focuses great attention upon the TIPS (Treasury Inflation Protected Securities) yield spread over conventional Treasury bonds. Toady, these spreads are relatively narrow.

Our reaction to this is that, we have a CPI that is officially 'cooked' to the downside. As the bond market still believes the CPI, the TIPS spread has little meaning.

Meanwhile overseas, competing central bankers recognize that inflation is picking up around the world. These central banks are slowly but surely raising their rates, even accepting the damage to their exporters as their currencies rise against the U.S. dollar.

To us, there appears a decisive case for our Fed to raise rates.

However, our Fed appears to be overly cautious of the possibility of a domestic economic recession, which they are mandated to avoid and fear. The indicators are mixed.

Only today, Bloomberg reported the results of one of their surveys of economists as showing that, 'a pickup in U.S. economic growth is becoming more elusive as climbing gasoline prices, falling home values and fewer jobs restrain American consumers.' These economists forecast our economic growth rate at 2.1 percent, the lowest in five years.

In addition, Bloomberg reported that Toyota, the world's largest automaker by market value, forecast its smallest profit increase in decades because of slowing growth in the U.S. and investment in new factories. We are not deterred by this statement (which includes high investment I new competitive factories). Nevertheless, we think the timing of this statement by a company that depends critically upon a confident American consumer, is suspect.

As our readers know, we have deeper concern that the busting of the residential housing bubble is inevitable and will be far more extensive than most mainline commentators feel it will be.

But we think it is going to happen anyway. We feel that, by turning away from stealth inflation and from the inevitability of the housing bust, the Fed has been tempted to do nothing, like a startled rabbit staring into the headlights of a motorcar.

Yesterday, former Fed Governor Alan Greenspan criticized politicians for their "awesome silence" on the funding of Medicare.

Today, we criticize the Fed for their 'awesome silence' on stealth inflation.

We feel that by 'chickening out' the Fed's delay in raising rates will store up severe inflationary problems for the future.

It will also mean that, when the Fed is eventually forced to raise its rate, it will have to be higher and for longer than if timely action had been taken today.

Despite the unwillingness of the Fed to raise its rate, as we feel is called for, and the continued liquidity driven upward roar of financial markets, we continue to urge our most conservative readers to remain cautious.

We continue to recommend a heavy asset allocation towards: cash, high coupon, high quality short-term bonds/CDs and gold, which we feel is poised for a strong rise, especially in dollar terms.

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DISCLAIMER: All of the provided information is believed to be accurate, however errors are possible. The opinions in the Commentary section do not necessarily reflect the opinions of Swiss America. Past performance of any investment is no guarantee of future performance. All investments have risk.

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