Fed Taking Risky Path

All signs point to another discount rate cut by the Fed's this week.

Fed expected to lower rates despite raging inflation

In a glorious bit of timing, the Federal Reserve is expected to cut interest rates on Tuesday for a third straight meeting, just days before government data are released showing some of the highest inflation rates in decades.

That's all you need to know about the Fed's balance of risks: Policymakers are much more worried about the illiquid credit markets and the possible hit that the credit squeeze could have on the economy than they are about the risks of inflation breaking out.

"Don't look now, but while we're in the midst of an easing cycle, the U.S. is facing a 4% inflation rate," wrote Avery Shenfeld, an economist for CIBC World Markets. "But for now, none of this matters, as both bonds and the Fed are focused on the credit crunch and its growth threat."

In other words, the Fed is worrying about a recession now and will worry about inflation later. It is the classic trade-off of the Phillips curve, which suggests that you can either have low inflation or low unemployment.

I think, however, that this anticipated move by the Fed's is a risky strategy, and is a departure from general Fed policy of the last 25 years.

Prior to the early 80's, the Fed managed monetary policy with a Keynesian view; i.e., used the Fed's policy moves to shift the aggregate demand curve in or out to try to maintain full employment. This unfortunately created some volatility (similar to oversteering a car on ice) which contributed toward the stagflation in the 70's.

With the arrival of Paul Volcker in the 80's, the Fed shifted policy moves to a monetarist view. Specifically, they have managed the money supply to keep a stable price level along the lines of the Simplified Quantity Theory of Money. The macroeconomic performance since that shift in policy view has supported the wisdom of that approach.

However, the current leaning toward more rate cuts to forestall a recession implies a that the Feds are either admitting that they really screwed the pooch with their previous rate increases, or there is a shifting back toward a Keynesian approach for policy making.

Under the Quantity Theory of Money, the only way the Feds should be considering a rate cut right now would be if inflation (mainly energy cost) is flat. But given the current increasing inflation rates, the Fed's should be thinking of standing pat or contracting the money supply to choke off even higher inflation down the road, not expanding money supply further with a rate cut.

Therefore, I have to conclude that Ben Bernanke is taking a big gamble that inflation will slow down on it's own. For that to happen, energy costs have to stop increasing soon, which is very unlikely. The Feds could be igniting a future inflationary period that will be very hard to stop down the road.

So far, I am very disappointed with Bernanke's decision making.