A L E R T

October 8, 2008

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Fed and Treasury Continue Propping the System
At All Costs (Particularly Inflation)

Intensifying Inflationary Recession Concerns
Overshadowed by Systemic Risks

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Following last week’s extreme measures by the Fed to flood the system with liquidity, passage of the "bailout" package on Friday (October 3rd), enabled further, unfettered Federal Reserve actions. The legislative package increased the debt ceiling and allowed the Fed to start paying interest on bank reserves deposited with the Federal Reserve Banks (lack of same had inhibited reserve expansion).  This week, the Fed set up a new facility to buy commercial paper. Despite these extraordinary actions, as well as actions taken by other central banks and finance ministries — including this morning’s coordinated interest rate cut — the systemic solvency crisis continues to intensify, with the financial markets remaining as unstable and volatile as anyone has ever seen. 

The Fed and administration will do anything to prevent a systemic collapse, the risk of which is as great a threat to national security as any the United States has faced in recent times. Accordingly, the Fed and Treasury will continue to create and spend any money necessary, to bail out any entities threatening stability, to twist any arm and to manipulate any market, medium, statistic or commodity price. That said, they indeed have the ability to support depositor safety, to prevent a functional collapse of the related financial services industry, and to prevent a deflation in the prices of goods and services. The cost of this systemic salvation, however, remains higher inflation in terms of prices for goods and services.

If the underlying system does not start to stabilize soon, almost any government action might be placed on the table. Such action could include anything from a banking holiday, and/or an all-inclusive FDIC guaranty, to some form of nationalization of the banking system.

The New York Times ["36 Hours of Alarm and Action as Crisis Spiraled," October 2, 2008, page 1] reported at least one pre-"bailout" consideration: "Although there were suggestions for a ‘bank holiday’ — a temporary nationwide closing of banks, which had not been done since 1933, to stem panicky withdrawals — Mr. Bernanke and Mr. Paulson dismissed the idea, fearing it would do far more harm than good."

Where systemic preservation is of utmost concern to the administration and the central bank, upside inflation risks exacerbated by the extraordinary systemic props, and recession problems already in play before the crisis and related exacerbation since, simply will be ignored or talked around, at present.

The U.S. stock market has been experiencing something akin to a controlled crash. What the Fed and Treasury are unlikely to accomplish in saving the system include any long-term artificial prop for the U.S. equity markets, as well as any long-term artificial support for the U.S. dollar. The Fed also cannot prevent an already ongoing and deepening recession or a continued, significant upturn in inflation. From Mr. Bernanke’s standpoint, concerns as to containing inflation or stimulating the economy are but secondary or tertiary to concerns as to preventing systemic collapse.

The general outlook remains the same. Recent dollar strength reflects a variety of factors ranging from outright supportive intervention, to flight to safety, to crosscurrents from trading forced by related derivatives held by troubled institutions, to general misperceptions that the systemic and economic conditions are relatively better in the United States than among major U.S. trading partners. Reality on the last point is starting to surface. With the underlying U.S. dollar fundamentals otherwise remaining as negative as they can be, the other factors mentioned should prove to be relatively short-lived.  

Beyond the current severe market instabilities, the long range outlook remains for heavy equity selling, for higher long-term treasury yields, and for heavy dollar selling and dumping of dollar-denominated assets, which eventually will evolve into flight to safety outside the dollar. When serious dollar selling begins anew, such should add some upside pressure to oil and gold prices. In any event, over the long-term, gold should rally sharply, reflecting its nature as a fundamental hedge against inflation and as a traditional flight-to-safety investment.

Barring extraordinary intervening events, my plan is to publish a brief Flash Update on Friday (October 10th) to look at this week’s money supply and trade numbers, with a special update on market and economic/ inflation conditions to be published late next week, in advance of the full newsletter.

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