About a million years ago, I worked on the foreign exchange desk at the Federal Reserve Bank of New York. The position didn't pay very much, but it was a wonderful first job. I conducted market intervention, and supplied forex market intelligence to top-level U.S. monetary officials. I witnessed, first-hand, the formulation of U.S. policy during the turbulent times of the early 1980s (when the prime rate was north of 20%!!)
I cannot speak highly enough of the people at the Fed. They are smart, dedicated, under-appreciated, and woefully underpaid. However, like most human beings, they are prone to significant errors of judgment, particularly at key turning points...
IMHO, the Fed's actions over the past month or two have been lame, and somewhat bizarre. I simply do not understand their obsession with inflation when 10-year notes are yielding below 4%, and when major financial institutions are crumbling before our very eyes. The current subprime/mortgage/credit market crisis is difficult to solve, but 25 basis point cuts, and $20 billion, two-week repos, are simply not going to get the job done.
The fact of the matter is, ex-subprime, the credit market cycle is just BEGINNING to turn down. In most categories, default rates are still at historic LOWS. In other words, things will likely only get worse from here. And given the unprecedented degree of leverage in the financial system, I think this is highly dangerous.
Inexplicably, Mr. Bernanke seems to be following the incrementalism of his mentor, Mr. Greenspan. Greenspan responded to the credit crunch (again, real-estate related) of the early 1990s with a series of 25 basis point cuts, stretched out over 2-3 years. Sound familiar? The result was unnecessary pain, a change in the Presidency, and a jobless recovery.
Some of the Fed statistics that I like to watch, such as the monetary base and total Fed credit, indicate that the Fed has NOT injected permanent reserves into the system over the last several months. In other words, the Fed has lowered rates, but they really have not eased yet. Like Nero, they are literally fiddling as Rome burns.
If I were running the show, I would take the federal funds rate IMMEDIATELY to 3%, jam short-term liquidity into the system, and restore a positive (200-300 basis points) yield curve... only then can the system regain its footing, and resume lending. By the way, in conjunction with this policy, I would also say that this was the full extent of the rate cuts, for at least 6-12 months. Not only would this demonstrate that the Fed is interested in restoring growth into the financial system, but it would also silence the weak dollar/inflation hawks.
I do not expect this Fed to take such bold action, at least not in the near term. Rather, we will probably get more and more days like today... weak data and a weak market... a protracted crisis that causes unnecessary pain, and only forces the Fed to eventually cut more than they wish.
Until the Fed acts, really acts, it is difficult to be constructive on this market. The financial, consumer discretionary, and small-cap sectors are all arguably in bear markets already. My portfolio is very conservatively positioned, and will probably remain so for some time.
I am particularly concerned about this coming earnings season. Many companies are facing the lethal combination of flagging demand and higher input prices. I fear that many managements will, in effect, thrown in the towel and report kitchen-sink type of quarters. Eventually, this may be a positive, but the near-term could be difficult.
The good news is, the Fed will eventually panic... and may well set us up for a nice market in the second half, if not sooner.