Fed already shooting blanks and Recession hasn't even started...yet

Since embarking on its rate cutting campaign last fall, the Fed has cut its interest rates several times in various increments bringing the Feds Fund rate from 5.25% down to 3%. Though seemingly Bernanke still has a few rounds left in the chamber, as I discussed earlier, if he cuts rates too low that would likely set-up a Liquidity trap scenario, negating the impact of the additional rate cuts.

It seems that my Liquidity Trap scenario has already been preempted by a transitory Stagflation scenario, which has rendered the Fed's latest round of rate cuts impotent. Since lowering rates twice in late January (.75% and .5%), long-term interest rates have been moving higher, not lower. The reason this is happening is due to the recent very high inflation readings - to wit, yesterday 's PPI print which was the highest since 1981.

These higher borrowing costs in combination with higher costs for food, energy, clothing, medicine, tuition...i.e. everything, is putting the squeeze on already highly leveraged consumers.

Yet, that hasn't stopped the man behind the curtain from continuing the rate cutting campaign, as just today Bernanke "signaled" to the markets that the Fed was preparing to cut rates again at its March meeting.

Why you ask, would the Fed continue to cut short-term rates and risk higher borrowing costs and living expenses for consumers? Easy - the Fed is cutting rates to steepen the yield curve which will allow banks to borrow short-term cheap and lend long-term i.e. the banks can make beaucoup $$$ via yield curve arbitrage. By doing so, the Fed is apparently more than willing to risk annihilating both the housing market and the general economy. It's a simple choice between Wall Street and Main Street and as always, Main Street loses.

As a post script, I would add, don't worry about this recent bout of stagflation. The deflationary spiral will soon enough obliterate commodities and any other bloated remnants of the great credit bubble.

NEXT UP: LIQUIDITY TRAP

It's February 8th, 2008 and the Fed has now cut interest rates at the most aggressive pace in decades. In January alone, the Fed cut 1.25% from the Fed Funds Rate. As the FFR now stands at 3%, the Federal Reserve is running out of bullets. To wit, the stock market (S&P 500) is lower than it was when the Fed first started lowering rates, and spreads between Treasury ("risk free") bonds and junk bonds are at their widest point in years, reflecting growing risk premiums.

This suggests the inevitability of a "Liquidity Trap". A liquidity trap is a situation where interest rates are lowered to such a point (i.e. 0-1%) that the Fed's standard tools for stimulating the economy no longer work. At very low interest rates, lenders are unwilling to lend, because it's not worth taking risk to receive such low returns. Would you put your money in a bank a) if you only received .5% interest and b) you were worried that you might never see your money again? Neither would I. So, those lucky few who actually have money, end up stashing it under their mattress or caching it in the backyard.

That's when the Government turns to "printing money", as in handing out "Stimulus checks", which is what Congress voted to do this week.

As this decline unfolds, I predict many more rounds of stimulus checks, however, each round will be less and less "stimulating". As I've indicated in my earlier post, the forces of deflation will exert a far greater contractionary force than can be offset by a few rounds of charity checks, especially when foreigners catch on and start pulling their money out of the U.S.

The fact that there are so few economists (any?) who see a liquidity trap on the horizon, is one of the most troubling aspects of this whole debacle.