Between Inflation and Interest Rates, Bernanke's In Deep

'Do you feel lucky, pal? Well, do ya?' - Clint Eastwood as Dirty Harry

In the middle of 2007 I presented you with a worst case scenario for the longer term health of the economy. That scenario demonstrated a weakening economy coupled with rapidly increasing levels of inflation. Unfortunately, that's exactly what we are faced with today. Bernanke is not only stuck between a rock and a hard place, but he could very well be blamed for the 3rd major down period in US history.

I will explain exactly when and why Bernanke will reverse his stance on interest rates. First though, we should address his next move. One more 25 basis point cut may indeed be in the cards, but it will be more of a response to market demand that economic policy. Regardless if he cuts on Wednesday or not, the easing cycle is likely to come to an end abruptly afterwards; don't expect an increase in rates anytime soon though.

>Over the past 10 years the market has followed the changes in interest rate sentiment dependably. If rates were increasing, the market moved higher, and if rates were being cut the market moved down; usually these changes begin with sentiment shifts, and that's what we are probably going to witness after the FOMC rate decision on Wednesday.

Initially that correlation is likely to continue based on sentiment changes alone, but not for long.

Let's start by taking a look at an estimate of Mortgage resets I captured from a May 2007 Article in Housing Monthly:

In the graphic above we can see that a very high number of mortgage resets will occur in 2008, but those should subside going into 2009. The burden of mortgage payments and adjustable subprime mortgages as they relate to declining home values has all economists worried. A borrower would be encouraged to walk away from his 'underwater' real estate if his mortgage burden increased beyond his capacity. Bernanke does not want this to happen, nor do any of the debt holders; that would devastate the economy. This is why interest rates are low and could possibly move slightly lower this week in the face of rapidly increasing inflation.

One of the major reasons Bernanke is aggressively cutting rates has nothing to do with the immediate weakness in the economy, or the perceived risk of inflection, but rather the premise is Mortgage resets demonstrated in the graphic above.

The problem: while he is prudently tackling the adverse impact that escalating defaults would have on the economy in the future, he is relinquishing his control of inflation.

Bernanke has lost control of inflation, and unfortunately he will probably not take steps to reverse the recent aggressive cuts until late in 2008, when the number of adjustable mortgages ease; that's too late. In the meantime, inflation will get worse while he waits. Inflation is like a snowball rolling down a hill of fresh powder....it grows, and grows, and grows.

Our economy, thanks to Bernanke, may be sheltered from some of the defaults that would otherwise lie ahead in a higher interest rate environment, and that's a good thing. However, thanks to Bernanke again, inflation may not only offset his initial effort, but it very well could cause the third major down period in US history to turn into an even Greater Depression.

Comments

[icandoitdon:]

"One more 25 basis point cut may indeed be in the cards, but it will be more of a response to market demand that economic policy."

that's exactly the problem. bernake has let himself get led around by the nose by wall street, which never met an interest rate cut they didn't like.

bernake should be fired. bring back volker. he's the only one with both the intellect and the cojones to fix this problem.

2008 Apr 29 09:26 PM

[icandoitdon:]

as for the problem of mortgage resets, your article says it all....it's only one piece of the problem and there is no assurance that the problem will even be fixed. homeowners might still walk away. would you continue to pay for a house that is worth less than your contracted price just because your mortgage is low?

this problem began with out of control lending using variable rate, short term financing for a long term asset. i don't feel sorry for anyone involved except for cases where fraud can be proven. let em go broke. the system can fix it self, however painful. instead we get helicopter ben...god help us.

2008 Apr 29 09:33 PM

[User 130076:]

icandoitdon has it exactly right, the Federal Reserve business is not to please wall street but to defend the dollar and keep inflation under control. If Greenspan would of done this we wouldn't of had a housing bubble.

2008 Apr 30 09:30 AM

[alwaysright:]

User 130076 is correct in that it started with Greenspan.

In his speech yesterday, I noticed that President Bush touted our high level of exports. We, in fact are exporting at a very high level because our goods are cheap. The dollar has lost a tremendous amount of value.

I have to believe that Greenspan did not do this in a vacuum. President Bush was probably in on the long range decision, seven years ago.

We are seeing the first "stagflation" since Carter. That it could have been prevented is obvious. That it is an unintended consequence of trying to increase exports may be true.

2008 Apr 30 09:47 AM

[Thomas Kee:]

alwaysright - I actually believe that the weakening economy was unavoidable in the 1970 and for the years that follow as well. It is a demographic issue, and policy changes can only lessen the impact; policy cannot prevent major economic cycles.

2008 Apr 30 10:17 AM

[Blue collar...:]

I continue to be amazed as "pundits" and readers alike continue to offer their theories, predictions, etc. relative to the economy, govt. attempts to manage money and resources, and various other financially esoteric details while completely ignoring other factors such as natural disasters (Katrina), "pop-up wars" which go completely out of control, escalating cost wise at least on an exponential basis. Not to mention other issues such as Demographics world wide, and the fact that there is an undeniable effort being made by parties known to support and otherwise work towards a "one world" concept beginning within the hemispheres or the continents and gradually spreading.

Gentleman, the whole enchilada is crap shoot from beginning to end and the survivors will not only have to be very lucky but very astute at sucking up, storing for immediate recall by any/every means possible, and analyzing as much information as technologically and humanly possible.

2008 Apr 30 12:33 PM

[Recourse Bob:]

The damage has already has been done, taking the federal funds rate from 5.25% to 2.25%. What difference does it make if Ben cuts the rate to 2.0%? Ben should quit messing with the market. Take the rate to 1% or 0% and get it over with. Then we can all move our money out of the U.S.

2008 Apr 30 01:06 PM

[sivere:]

Let's start over with a sane system:

TakeBackTheFed.com

2008 Apr 30 02:28 PM

[User 15926:]

Why stop at 2%?Why not have negative interest rates? and negative income taxes,where people are sent money for being unsuccessful!Savings and productivity should be penalized in the delusional world that Ben lives in.His policies are more dangerous to the US economy than the war in Iraq and Afghanistan put together;

2008 Apr 30 06:24 PM

[Austrian Sc...:]

The Fed is bailing peoples bad mortgage investments at the expense of everyone else. How is this helping the country?

2008 May 01 02:54 AM