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The September Federal Reserve meeting becomes a major test for Bernanke’s reign as chairman. Wall Street responded positively to the discount rate cut but now the addict that we described earlier will be looking for its next fix. It wants it drug and that drug is liquidity. Since the cut, central banks worldwide have injected more than $300 billion dollars of liquidity into their banking systems through repurchase agreements and other arrangements. This tells me that the problems are not over. They have only moved the liquidity crisis to the backburner hoping, like in March, it corrects itself. Even with the injections, the commercial paper markets remain tight. Last Wednesday, LIBOR increased to 5.72% its highest rate since January of 2001. The Australian central bank said on Thursday that they will buy bonds backed by mortgages effectively monetizing debt. The Bank of England intends on offering 4.4 billion pounds ($8.9 billion) on Sept. 13 at the benchmark rate rather than the penalty rate to inject liquidity. The ECB issued 42.245 billion euros into the money market with the Federal Reserve injected $31.25 billion, its largest move since injecting $38 billion on August 10. Richmond Federal Reserve President Lacker told the markets that any move in the primary target rate will depend on the economic outlook rather than the market outlook. St. Louis Federal Reserve President William Poole, an inflation hawk and voting member of the FOMC, mentioned yesterday that the US economy was near full employment and policy makers need to pursue policies which ensure full employment and price stability. Henry Paulson has warned investors that there is no quick solution to the problems in the financial markets and there would be a period of adjustment. In the hedge fund world, the problem now is one of a Darwinian nature where the weakest in the herd are being thinned out. As the weakest (worst performing) hedge funds close up shop, they sell securities, pay down margin, and remove liquidity from the system but create a stronger playing field down the road as the remaining funds absorb the weak funds capital, reallocate, and leverage back up. If the Federal Reserve cuts rates it will appear to be bailing out the risk takers leaving their credibility significantly harmed. The Federal Reserve needs to allow the markets to experience the ramifications of their actions so that they appreciate the risks they undertake. Ultimately, the success of Bernanke’s reign will be measured like his forbearers, in his ability to control inflation. Bailing out risk takers is not in the charter and risks comparisons with the Federal Reserve chairmen of the 1970’s. In Bernanke’s recent Jackson Hole speech he stated that the data coming out between now and the September 18th meeting will be extremely important as to gauging the general public’s reaction to the problems on Wall Street. The data in so far has July personal income rising by 6.6% YoY with personal spending up 4.7%. August ISM data (52.9) showed a manufacturing sector expanding at a rate consistent with annualized GDP growth of 3.4%. Most indices showed a slowing trend but remained above the growth level of 50. The non-manufacturing ISM index came in at 55.8 for August, better than expected. The new order component was up to 57 from 52.8 in July but the employment component fell to 47.9, the lowest reading since July 2004. The Beige Book summary of data indicates that in all 12 Fed districts economic activity continues to expand, albeit at a slower pace. The jobs report issued today needs to be dissected before determining its effect on the economy. Skimming the surface, employers cut 4,000 jobs in August and job growth was lowered in both May and June. But you need to note that since the beginning of the year job growth has been boosted through the birth/death model. Without the boost, the jobs number would have turned negative much earlier. On a global basis, the JP Morgan Global Manufacturing Index came in at 53 for August, the fiftieth successive month above 50, the no-growth level. The August retail sales and industrial production data will be released before the meeting but as it stands now it does not appear as though the housing crisis is spilling over to the broader economy. As of this moment, I believe that the odds of a Fed Funds rate cut are less than 50%. How the market reacts in the days leading up to the meeting along with its immediate reaction afterwards will tell us a lot about where we go from here. There is a possibility that Bernanke will choose to keep rates on hold in order to penalize the risktakers and flush excesses from the system while continuing to leave the door open to changes between meeting periods.
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