Have the Effects of the Fed's Shock-and-Awe Tactics Worn Off?

Includes: DIA, QQQ, SPY
by: Grace Cheng

In this recent financial crisis, the Fed has pulled out all its big guns: it helped finance JP Morgan’s (NYSE:JPM) purchase of floundering Bear Stearns; it gave credit lines to institutions it otherwise wouldn’t have, took “worthless” assets as collateral in exchange for loans, and basically anything it could think of to restore faith in the markets.

There are many who say that some of these things are “reckless” and can only lead to further inflation, and that it is a wasteful spending of taxpayers’ money. But right now, the bulk of inflation is coming from oil and other commodities, and it seems caution can be thrown out the window. Besides, if these things can only inspire faith in the markets and they can turn around, then it will be worth it.

For a few weeks, it seemed these tactics might have worked. The markets took to optimism and moved higher. It didn’t matter that oil was going through the roof, that home owners were increasingly defaulting on loans, or that financial institutions had billions in losses and writedowns. The worst must be behind us, or so the market hoped.

Last Friday seemed to bring the markets to a brutal awakening: the unemployment numbers were terrible, oil had its biggest ever daily gain to a new record high, and the Dow fell the most in 15 months.

Is this a sign that the Fed’s shock-and-awe tactics are wearing off? How much more can the Fed do to help? It can’t very well cut interest rates further, that would only increase inflation, make the US dollar fall further and oil prices rise. The Fed is already providing lines of credit to financial institutions which aren’t banks and has indicated its willingness to help any that are in trouble.

The most important thing the Fed has going for it is the faith that investors place in its “all powerful” nature in controlling financial policy. That faith is what pushed the markets up after the Fed’s bailout of Bear Stearns.

If you compare the current crisis to a deck of cards that’s falling, then you could say the Fed is running around trying to stick its cards where others collapse so as to keep the system intact. But how many more cards does the Fed have up its sleeve? If investors feel the Fed has overextended itself and run out of tricks, then we might see more stock dumping and commodity hoarding like we saw on Friday.