This is One of those Fulcrum Moments for the US Dollar and Hence World Economic Stability
Market expectations had been wishful-thinking a monetary loosening over the past year (i.e. a quasi-government-controlled increase in the availability of credit due to their confidence in the Fed's success in controlling inflation). But the Fed has done its best to convince players that there would be no such thing.
Because we all are skeptical of the Fed's word, ever since Forked-Tongue Al (former Fed Chairman Alan Greenspan) taught us that our monetary regulators needed secrecy to function, we still have trouble believing them; but ever since Ben Bernanke got into Al's hot seat, they have shown themselves serious about turning over a new communicative leaf through surprising forthrightness and clarity. They have simplified their sentences and acknowledged their shortcomings--at least many of the board members have, if not all.
The problem they still face, however, is at once simple and monstrous. According to their mandate they must control inflation, and at the same time they must not let the economy tank. This turns out to be very complicated, because they do not in fact possess tools efficient enough to exert good control over the money supply. Rather, they have only a negative, catalyst-like, clumsy, and belatedly-reactive influence on it, that tends to do more harm then good because of its unpredictability. (See my discussion in an article published at Prudentbear.com.)
And yet the credulous market players still want to believe in the Federal Reserve god. So here's the deal as I see it:
There are three possible outcomes for our economic equilibrium at the present conjuncture:
1. The Wishful-Thinking Scenario. The dollar rebounds (as it desperately wants to do), because the world has faith in the American "tallest dwarf" monetary management team (whether or not it deserves it). The wiser Fed continues to take a back seat, steering monetary credit on an even, transparent, and conservative course, perhaps even with the intention of phasing back their monetary role. At the same time, they step up aggressive action to defend the consumer against fraud, by curbing financial abuses like those that led to the recent subprime debacle and by pushing through and implementing BIS-originating capital-adequacy legislation. The dollar-instrument-holder stampede for the exit now taking place (mostly by trading partner central banks) proceeds calmly without overly affecting the markets, because the players somehow manage to agree to cooperate in making this a smooth transaction. Although the dollar continues its 2-5% "slow" inflationary descent to near zero, the smarter players have become accustomed to it and include this factor into their expectations. (I guess it's to hell with the little guys who don't know any better.) Gold slowly loses its luster and settles at around $400-$450 for the coming years, assuming there aren't any security scares. Oil drops back down to way below what everyone is expecting. Stagflation fears subside as housing and the rest of the economy pick themselves back up and trudge forward. All's right with the world. Well, who knows. Maybe.
[Thanks to spaceandmotion.com for the image.]
2. The Out-With-A-Bang Scenario. The dollar starts to rebound (see above) as players expect the Fed to manage inflation. The Fed, in reaction to pressure from the rising core CPI stats, increases rates just a bit. This show of firm willpower spooks the over-leveraged financiers. General interest rate increases speed up, putting the more fearless risktakers in jeopardy. US government bonds continue their drop (remember, their price is a function of general interest rates). The housing market recoils; home prices drop; foreclosures multiply. Consumer sentiment drops as their own credit costs rise. They slow spending. We're on a recessionary course. The dollar does a U-turn. Gold returns to being the safest haven and speculation pushes it to well over $1,000. The FDIC will step in to save some of the larger victims of the bloodbath. Who knows what the Fed will do then.
3. The Out-With-A-Whimper Scenario. The dollar's hint at a lift is a dud. The stampede away from the dollar picks up speed. The carry trade unwinds with a snapping sound. The economy continues its descent into stagflation, with the figures telling contradictory tales and the CPI continuing to play footsie with the Fed's "comfort zone." After a year or so, when unemployment starts to set in, the Fed loosens; and the dollar drops to superseding new lows. Over a few months, the US loses its status as the leading economy of the world, and the dollar is finally recognized for what it is: an unfulfilled fiat promise, just like all the others. We lose our monopoly on seignorage. Oh, and inflation starts up in earnest as the Fed scrambles for a solution. Gold rises inexhorably. Hopefully, we take our medicine a-la-1980s and go through another Reagan revolution, this time for good.
Now, if only I knew which one it will be.