Thoughts On The Current Economic & Financial Markets Situations- Part Two

I wrote about the current economic situation in yesterday's post here.

Today, I'd like to conclude with a review of the other major question of the day- wither our US financial markets? Are they headed for a prolonged downturn of several to many months, or a short 'correction' of just a few months? Is the Fed 'behind the curve' on easing, or wrecking longer-term economic fundamentals involving inflation and the value of the dollar? Are financial markets panicking, or correctly reacting to both economic and financial market news?

From my own academic economic training, study of the field as a business person since the late 1970s, and reading of and listening to various pundits, I believe that the Fed is now easing unnecessarily. As Brian Wesbury contended Monday morning on CNBC, the Fed's easing of late 2007 and, more recently, the ad hoc 75bp, are "baking in" serious inflation risks for our economy in the next few years.

Even this morning's GDP-related core inflation number was up, +2.7%. Only last year, Fed Chairman Bernanke stated that he was uncomfortable when inflation began to rise above +2%.

Some believe, and I agree with them, that our current troubles stem, in part, from Fed Chairman Greenspan's excessive easing in the post-9/11 era. This laid the foundation for the housing bubble and related mortgage problems now beleaguering some of our financial institutions. As such, Greenspan put us on a roller coaster of easy money, overreaction by the financial sector, asset value destruction, and, then, more calls for even lower interest rates to reflate the economy and provide "liquidity."

Here's something to consider. Only two years ago, in the wake of hurricane Katrina, the government pushed ethanol as a long-term solution to looming, oil-price-based inflation. Leaving aside the separate inflationary effects of this misguided move on the price of corn, and all of its downstream derivative food products, this would argue that we should be concerned about anything that excessively, and unnecessarily drives the dollar-price of oil up.

And guess what is the number one way to do that, in a controlled fashion? Cut the US interest rate, thus cheapening the value of the dollar. This causes the dollar-denominated price of oil to rise, thus, automatically importing more inflation into the US economy.

Every Fed easing in the last 8 months has effectively goosed inflation for all dollar-priced commodities.

On this basis alone, the recent easing, combined with what fixed income futures tell us are 'market expectations' of further easing, will almost certainly continue to exacerbate the US inflation rate in coming years.

This is partially to what Wesbury referred in his comment about things now looking a lot like the 1970s.

In truth, as Wesbury has pointed out in his on-air comments and Wall Street Journal editorials, most of our economy is sound, or at least only slowly-growing, not shrinking. This morning's initial 4Q2007 GDP number was +.6%.

Of course, this was immediately seized upon by the always-gloomy CNBC staff- Liesman and Haines, to name two- as weaker than the expected +1.5%.

But it's still positive. And as former Fed Vice-Chair Alan Blinder noted, it's going to be revised, probably, but not necessarily, upward.

And today's ADP employment number came in unexpectedly high- something like +130,000 jobs. Again, the primary determinant of recession, falling job numbers and aggregate incomes- is still missing.

Against this backdrop, why is the Fed cutting rates?

I think it is, sadly, unwise political accommodation by Bernanke & Co. to the Congress and Wall Street. Rather than stay the course against inflation, and at least attempt to honor the spirit of the great, late US Nobel Laureate economist Milton Friedman by moderating the rate of monetary base creation, the Fed seems to be more concerned with its public image.

In my opinion, they are a select few economists who are supposed to be intelligent, reasonably well-educated in their craft, accomplished, and deliberative. And sufficiently confident to be as insensitive as possible to the constant clamor of financial markets and the populace for easy money.

As I have written before in this blog, and various pundits have also contended, our current financial markets turmoil has had more to do with counterparty risk than liquidity. Therefore, easing rates affects market psychology more than it actually provides needed, otherwise-absent liquidity.

Of course, it also causes a loss of value among foreign holders of dollar-denominated assets, causing more pressure to replace the buck as the world's reserve currency. That's a change for which our economy and financial system are totally unprepared.

So, in addition to the mistaken fiscal stimulus package working its way through Congress, we are adding to our economic troubles by the Fed's needlessly, in my opinion, cutting interest rates.

As Wesbury noted recently on CNBC, we're all going to be feeling some pain in about 24 months, when inflation begins to crest.

How will we react, as a society, to, say, a +3-4% GDP growth rate with a 5% annual inflation rate? That's negative real growth. And an inflation rate higher than the one that led Nixon to institute wage and price controls almost 40 years ago.

Somehow, we seem to have lost our memory of the post-Carter era solution to excess government taxation and spending, high inflation and too-easy money. So we seem to be heading that way again. Inflation rates of the Reagan era, well below 2%, are now a distant memory. So, it seems, are the low tax rates.

The final conclusion, for purposes of this blog, is how all this would affect equities in the longer term. That's a no-brainer, isn't it? Rates of inflation above 4% and growth not much more? Equities will struggle, as a reflection of the struggling economy that they represent.