TheWind's  Instablog

Today's beige book has nothing new from what we all know:

The Fed’s summary of current economic conditions, known as the Beige Book, said the economy improved in 10 of the central bank’s 12 districts last month. The report is used as a basis of discussion at policy meetings, which typically follow two weeks later. The Federal Open Market Committee gathers on Jan. 27.

My suspicion is that a "sluggish" recovery is really what Fed wants.

Background
The Fed cut the federal funds rate -- the benchmark US interest rate -- to near zero per cent in December 2008. It has also put in place a raft of emergency programs, including one to purchase $1.25 trillion worth of mortgage-backed securities (MBS), to help guide the US economy out of the worst recession in some 70 years. The Fed's extraordinary actions more than doubled its balance sheet to around $2.2 trillion.

MBS is extremely interest-rate sensitive, which means that Fed is set to lose money if they raise interest rates.

Therefore, here is the dilemma: if Fed raises interest rates rapidly, it will wipe out Fed's equity; but if Fed react to the inflation too slowly, it will still damage its portfolio eventually plus the Treasury and equity market.

Why running-out-of-way inflation is so bad?  Because that means Treasurys are set to decline substantially, so that their yield can match with the outside inflation.  A declining Treasury market rarely impacts the equity market, only if and when the Treasurys are not so depressed that they actually "compete" investor's money with the equity market.  Otherwise, we are at the risk of 1986 stock market crash.

A robust recovery is bound to trigger inflation.  When that happens, Fed will be forced to act accordingly.  The choices Fed is facing are neither appealing when the recovery is too fast.  In fact, we feel Fed actually "desires" a slow, moderate recovery.

Wall Street's trading floor knows this trick: a strong data means more imminent tightening and liquidity pullout.  For the bulls of stock market, they also want a slow recovery.

The only question we have is whether Fed, or anyone else, can really control the pace of recovery.  Or, will it be a recovery in 2010?


Disclosure: None related in this article, but generally bearish on Treasurys and equity