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The Fed's Dilemma

March 10, 2007

The Federal Reserve System, central banking system of the United States, referred to as the Fed, serves as banker to both the banking community and the government. The Fed also issues the national currency, conducts monetary policy, and plays a major role in the supervision and regulation of banks and bank holding companies. In the United States these functions are the responsibilities of key officials in the Federal Reserve System, which is made up of a board of governors, chaired by Ben Bernanke. The Fed’s actions typically have a significant impact on interest rates and the stock and bond markets.

Last week the Federal Reserve open market committee voted to keep overnight lending rates to banks at 5.25%. That was no change from the last few sessions. When the verbiage that the Fed uses to explain where they are regarding interest rates was released, the stock market rallied and the Dow Jones average gained about 300 points. The reason for the rally in stocks was that the Fed (Federal Reserve Open Market Committee) gave market bulls a hint that the Fed’s bias towards a raise in interest rates was less than previous sessions, even though there may be a threat of inflation. At the same time as the market rally in stocks was in full gear, the bond traders were saying that they did not believe this was a correct interpretation of the Fed’s statements. The bond traders sold bonds, which translates to higher interest rates that would signal a rate hike; not cut.

The market rally in stocks and the sell off in bonds is just trading by traders in my opinion. The reason I say that is the fact that nothing has changed regarding the Fed’s dilemma. The Fed could lower interest rates because the housing numbers continue to be bad, the overall economy is weakening and the spread between short term rates and long term rates are inverted. The Fed could raise rates because inflation is still trending up and job creation as reported by the government is still strong. There are many people in the lower rate camp as well as the raise rate camp. My belief is that for the time being the Fed will do nothing. It is the only choice, and that is the dilemma.

History tells us that the Fed will not lower rates to bail out a weak housing market or a slumping stock market, but they will raise rates to slow down inflation. A raise in rates would further harm the housing market and stock market; a cut would add liquidity to a growing inflation problem.
Neither scenario is good for the consumer, or economy. So let’s wait and see how this plays out in the coming months.
No matter what happens, it is the perfect opportunity to properly diversify your investments across all asset classes to prepare for whatever way this economy turns.