Between Inflation and Interest Rates, Bernanke's In Deep

by: Stock Traders Daily

'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 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.