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September 23, 2007

Did the Fed fix the Problem or Are Their Actions a Sign of a Bigger Problem?
by Tim Wood

I have said before in my newsletters that the Fed's biggest fear is deflation and I believe that the move earlier this week proves that point. As the stock market began to decline in August the Fed began extending the discount window, encouraged banks to come to the discount window, and cut the discount rate. I reported here a couple of weeks ago that based upon the 3-month T-bill rate and my Trend Indicator that we have entered into an environment in which lower short-term rates should prevail. So, the fact that a cut was made came as no surprise. But, the shock was that the Fed cut both the Discount rate and the Fed funds rate by a half point. In my opinion, this was a drastic measure and it serves to show the Fed's true colors and it absolutely confirms that they are scared to death of deflation.

The message is that the Fed will create even more monetary inflation. They would obviously rather see $100 plus oil and gold sitting on the moon than to allow the markets to make a very normal and natural correction. Technically, many asset classes have been trying to form tops. Gold as an example had been rather soft and sloppy for all of 2007, as has silver. The stock markets around the world still are operating within one of the longest 4-year cycle advances in stock market history. This cycle has been stretched because of the constant manipulative efforts to prevent its natural tendency to correct. The reason the Fed continues to try to inflate is simply because they know the consequences when, not if, but when, the house of cards that they have helped to create folds. These actions send a very clear message. The reason they are afraid of even a 5 to 10 percent correction in the stock market is because they fear that any such decline will be the straw to ultimately collapse this house of cards.

I say these things because I am looking at over 110 years of stock market data. I know what the statistics suggest, I know what the cycles suggest and I know that the cyclical down turn in housing leads the stock market. The problems that we have begun seeing in housing is only the beginning and the Fed knows all of this as well. Proof of this is in their actions and their fears of deflation.

But, you don't have to believe me. Further proof of the Fed's fears of deflation can be found in Ben S. Bernanke's speech before the National Economists Club in Washington, D.C. on November 21, 2002. This speech was titled Deflation: Making Sure "It" Doesn't Happen Here. In that speech Mr. Bernanke makes it very clear that the Fed indeed fears and is prepared to fight deflation at virtually all costs.

In this speech when addressing the Prevention of Deflation Mr. Bernanke states:

"As I have already emphasized, deflation is generally the result of low and falling aggregate demand. The basic prescription for preventing deflation is therefore straightforward, at least in principle: Use monetary and fiscal policy as needed to support aggregate spending, in a manner as nearly consistent as possible with full utilization of economic resources and low and stable inflation. In other words, the best way to get out of trouble is not to get into it in the first place. Beyond this commonsense injunction, however, there are several measures that the Fed (or any central bank) can take to reduce the risk of falling into deflation.

First, the Fed should try to preserve a buffer zone for the inflation rate, that is, during normal times it should not try to push inflation down all the way to zero.6 Most central banks seem to understand the need for a buffer zone. For example, central banks with explicit inflation targets almost invariably set their target for inflation above zero, generally between 1 and 3 percent per year. Maintaining an inflation buffer zone reduces the risk that a large, unanticipated drop in aggregate demand will drive the economy far enough into deflationary territory to lower the nominal interest rate to zero. Of course, this benefit of having a buffer zone for inflation must be weighed against the costs associated with allowing a higher inflation rate in normal times.

Second, the Fed should take most seriously--as of course it does--its responsibility to ensure financial stability in the economy. Irving Fisher (1933) was perhaps the first economist to emphasize the potential connections between violent financial crises, which lead to "fire sales" of assets and falling asset prices, with general declines in aggregate demand and the price level. A healthy, well capitalized banking system and smoothly functioning capital markets are an important line of defense against deflationary shocks. The Fed should and does use its regulatory and supervisory powers to ensure that the financial system will remain resilient if financial conditions change rapidly. And at times of extreme threat to financial stability, the Federal Reserve stands ready to use the discount window and other tools to protect the financial system, as it did during the 1987 stock market crash and the September 11, 2001, terrorist attacks.

The financial conditions began to "change quickly" in the wake of an "extreme threat to financial stability" in August. As a result, the Fed acted precisely in accordance with these comments underlined above.

Third, as suggested by a number of studies, when inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates. By moving decisively and early, the Fed may be able to prevent the economy from slipping into deflation, with the special problems that entails."

This is exactly what the Fed did at the most recent Fed meeting on September 18th. Note, that he mentions such aggressive actions in light of "Special Problems." Also note that this is a third tier line of defense in regard to deflation. Hello! As I have said all along, the actions by the Fed is proof that the markets are indeed at risk just as the technicals and the statistical data has been suggesting. Again, I want to emphasize that the Fed is afraid to let the markets correct because they know that any such correction is likely to get out of hand.

Another issue I see here is that the Fed's latest actions are in spite of the fact that oil is now over $80 a barrel and with gold well over $700, not when inflationary levels are low. Again, this is also evident that their fear of deflation is so great that they are willing to create monumental monetary inflation all in an effort to get the consumer spending and to further re-inflate the stock market, regardless of the fallout. One of the many flies in the ointment is that Mr.Bernanke seems to assume that by lowering interest rates there will be an endless supply of credit-worthy consumers capable and willing to take on more and more debt. With us now seeing the sub-prime issues beginning to come to a head and in the wake of the housing boom, home equity extraction and the re-financing that took place between 2001 and 2005, the supply of able consumers is certainly not what it used to be. All the while, the average person on the street seems to be completely oblivious of the current risk to the financial markets. Rather, they are worried about missing out on a "New Bull Market." "New Bull Market?" What? There is no new bull market. This is a very extended move that has created a financial train wreck waiting to happen. I have repeatedly warned about the fact that the stock market is operating in an over extended 4-year cycle and few seem to be willing to believe or listen to this data. Well, it's true. The data does not lie. The markets are indeed stretched, the Fed is afraid of even the small correction, deflation is their worst nightmare, their actions are proof of their fears and of the financial crisis that is now facing the market and there is a financial train wreck coming. You have been warned, Again!

I have begun doing free Friday market commentary that is available to everyone at www.cyclesman.com/Articles.htm so please begin joining me there. Should you be interested in analysis that provides intermediate-term turn points utilizing the Cycle Turn Indicator on stock market, the dollar, bonds, gold, silver, oil, gasoline, the XAU and more, those details are available in the newsletter and short-term updates. In the September newsletter I also provide specific details about the ongoing state of the stretched 4-year cycle and what is expected on even a longer-term basis. The rally that began on August 16th was expected and the key now is what the Cycle Turn Indicator does. A subscription includes access to the monthly issues of Cycles News & Views covering the Dow theory, and very detailed statistical based analysis plus updates 3 times a week.

Tim W. Wood
Cyclesman.com

Copyright © 2004-2008 by Tim W. Wood. All rights reserved.

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