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Bill Bonner in The Daily Reckoning takes on the Fed’s big dilemma. How can it simultaneously fight inflation and deflation of asset prices?

Whatever the feds do, you can be sure it’s going to involve a lot of doublespeak.

According to AP, they are “looking for a new message to keep inflation expectations in check, without having to boost interest rates.”

It’s to be a “finely tuned message” to “ward off inflation,” says AP.

We thought raising interest was the best way to do that. Then again, so did ex-Fed chief Paul Volcker, and look what happened to him.

Brown Brothers Harriman economist Marc Chandler, quoted in BusinessWeek, says it’s the third paragraph of the Fed’s post-meeting statement that’s the one to look out for. The third paragraph will deal directly with the Fed’s assessment of the inflation risk…

Here the wording is likely to stiffen a bit to reflect that commodity prices have continued to rise and that inflation expectations appear to be creeping higher. The FOMC will likely signal not just that it will “continue to monitor inflation developments carefully,” as it said in March and April, but will likely indicate that it is on heightened alert or something in that vein.

More from Bill Bonner. He says the Fed is “fighting a mighty war against deflation… and losing.”

Surging inflation all over the world is putting pressure on the Fed to raise rates. But raising rates in an economy with rising employment and falling house prices could be disastrous.

On the other hand, not raising rates could provoke a disaster of its own. It could cause the dollar to collapse as prices soar.

On Friday, the Dow fell 220 points. Gold held steady at $903. Oil rose $2 to $135.

Here at The Daily Reckoning headquarters our “Crash Alert” flag has been up so long it’s almost in tatters. Even we don’t bother to look up any more. We know what to do – keep our money in cash…in gold…in Japan…and, lately, in emerging markets.

But the best place for you money over the last year has been energy. Energy stocks on the S&P are up about 20%. The worst place for your money has been the financial sector, which is down about 36%. The banking index, BKX, was at 110 last year. Now, it’s below 65, down about 40%.

The Fed is fighting a mighty war against deflation… and losing. Its cheap money and credit no longer seem to help its buddies on Wall Street or the little guy out on the prairies or down in the bayous. Instead, the money drives up consumer prices…and ends up in the hands of the energy exporters – Russia, Venezuela, and the Gulf. The Financial Times reports that there are 15 times as many houses for sale than there are buyers looking for them. And now, it appears that the very temporary boost given to the U.S. economy by the tax rebates is fizzling out. Look out below…

But you rarely get what you expect from the financial markets; instead, you get what you deserve.

Wall Street is getting what it deserves. The hotshots made fortunes by loading up the whole country with debt. Finally, they’re taking some losses.

This point deserves a brief pause. Stephen Cecchetti, writing in the Financial Times , argues that Wall Street’s innovations of the last 20 years were a great thing, in that they helped cause ‘the Great Moderation.’ He’s referring to the period of steady growth, with less volatility, over that period. The key to it was securitization, he says. By turning loans into credit-backed securities, the financial industry not only did itself a huge favor, it did the whole world one too, he believes.

How so?

“Not only has the overall quantity of financing increased, but also these innovations have allowed high-risk borrowers access to financing…there is a clear sense that financial innovation has been responsible for reducing the previously direct relationship between consumption and income.”

Mr. Cecchetti, a professor of finance, sees this extra credit as a triumph. We see it as an attractive nuisance. Like a hand grenade on a playground, the kids are bound to start playing with it…until it blows up.

In 1985, there were only $1.6 trillion in home mortgages. And only $500 billion worth of them were in pools used to back securities. Twenty years later, total mortgage debt approached $10 trillion, with $7.5 trillion of it securitized.

This “financial innovation has been responsible for reducing the direct relationship between consumption and income,” he adds.

Again, the professor regards this as a victory. To us, it is the kind of victory won by George Armstrong Custer at the Little Big Horn. The financial innovations of the last 20 years lured Americans to go deep into dangerous territory – increasing their spending, even though their incomes were stagnant. This “smoothed” growth in the world economy. Economists loved it. But it wasn’t long before the U.S. consumer had slumped over – wounded by excessive debt.

America’s central bank tries to come to his rescue…but when the cavalry finally arrives, they gallop right over him.

Related Articles

• Inflation Now Enemy Number One for Fed?
• Americans Must Cope With a Lower Standard of Living
• Don’t Hold Your Breath for Another Fed Rate Cut

About the Author

Best-selling investment author Bill Bonner is the founder and president of Agora Publishing. Owner of both Fleet Street Publications and MoneyWeek magazine in the UK, he is also author of the free daily e-mail The Daily Reckoning and three best-selling books, Financial Reckoning Day: Surviving The Soft Depression of the 21st Century, Empire of Debt: The Rise of an Epic Financial Crisis and Mobs, Messiahs and Markets..

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The Daily Reckoning offers a "uniquely refreshing" perspective on the global economy, investing and the ability to live well in uncertain times. You will learn what you can expect from today's markets and how to prosper in the face of uncertainty.

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