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June 07, 2006

Bernanke's Bag of Hammers
by Brady Willett

After one of the most concerted rhetorical attacks on the threat of inflation in recent memory, Bernanke's Fed has pushed the odds of a June rate hike above 80%. It goes without saying that stocks - which rallied last week as June rate hike expectations plunged below 50% - have been hurt this week.

Unless Bernanke and company want to convince the markets that they see the Fed's rate hiking campaign continuing into the second half of 2006, they need to zip it. To be sure, three Fed officials (Bernanke, Bies, and Poole) have spent the last two days waving their inflation fighting flags because they wanted investors to understand that a rate hike at the end of June was a forgone conclusion. Mission accomplished. Any further flag waving could make investor's think that the Fed has gone mad. After all, in March the Fed was contemplating a pause, in April Bernanke was suggesting a pause regardless of the inflation readings, and the pause theme played in theaters across the world in May. All of sudden - as if the Fed never had access to commodity prices - the pause story has left the building?

In other words, the reason why the Fed needs to zip it is because it is impossible to micromanage investor expectations and financial markets. Moreover, any consistent attempt to do so is likely to achieve undesirable effects. Here is a hypothetical: the Dow Jones Industrial Average plunges by 1,279 points tomorrow and the Fed needs (or thinks they need) to intervene to stop the selling. With one phrase - 'liquidity baby!' - Bubbles' Greenspan would be able to bounce the Dow higher by 700 points the next day. By contrast, Bernanke, already armed with the baggage of his pause flip-flopping and 'lapse of judgment' comments, is perhaps only able to will a 200 point rebound...

Point being, in an attempt to acquire inflation fighting credibility the Fed could lose their crisis fighting abilities. This would especially be the case if the Fed, either via an incredible overshoot in rates or continued display of disjointed verbiage, were to play a major role in sparking such a crisis.

And yes, the Nikkei dropped below its 200-DMA overnight.

Brady Willett
FallStreet.com

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