The confidence game now demands that the Fed take action against inflation and strengthen the dollar. The two Jacks are the cards central bank policymakers are energetically and enthusiastically waving in our faces. But it’s misdirection – that’s the game.

By waving those two cards, the Fed implies that interest rates must rise to stem inflation and support the dollar.

But rates cannot rise. The game is fixed. And most investors don’t even realize it.

The Fix Is In

The Fed is not really worried about inflation (on a relative basis). It’s true that inflation has reared its ugly head, and is inflicting both damage and pain on the U.S. economy. But the collective expectation for inflation and its resulting pressures are not here yet. The Fed knows that as we are falling deeper into recession, jobs will be lost, wages will not rise, consumers will not be buying. There’s no real need to raise rates. The central bank just needs to show us that it has that card; it’s part of the game. It’s about giving us confidence in its resolve to do battle with the evil forces of inflation.

The same is true of the Fed and the dollar. It’s only been in the past couple of weeks that the current “Bush-league” administration and the Fed have even acknowledged the dollar’s big swoon. Why the delay? Because they knew consumers were tapped out and that the only growth (which they point to as part of their confidence-building shell game) is being generated by exports. The dollar has fallen so far that our U.S.-made goods and services are essentially “on sale” when compared to wares made in countries whose currencies have zoomed to record highs against the greenback.

I hope I’m not confusing you. But if you are a bit bewildered, let me provide the “spoiler” here by telling you precisely why the “money card” stays face down: Interest rates cannot go higher.

The credit crisis has blown our banking system apart, and the fallout from that explosion has smashed our entire capital formation/borrowing & lending infrastructure. And the capital that formally emanated from that sophisticated system is what makes the merry go round.

Rates now have to stay low in order to jump-start these crucial liquidity flows and re-ignite demand. While it’s true that maintaining low interest rates will further fuel inflation, the Fed really has no choice. Or perhaps it’s a Hobson’s choice. You see, if the central bank actually raises rates to combat inflation, adjustable rates on mortgages will rise, setting in motion a whole new round of housing defaults, which will lead to an escalation of bank write-downs, which will torpedo stock prices, which will force institutional investors to liquidate holdings to raise capital. The same will happen out in the marketplace, where companies with debt coming due will find it impossible to refinance, touching off still another avenue of defaults, losses, and write-downs.

Better to keep rates low now – and believe that it can throttle back inflation later on.

Beware of the proverbial dead-cat bounce. Keep your eyes on the prize. There will be a market bottom. It’s not clear how long that will take. But keep this in mind: It won’t be a buying opportunity until the “shills” have been shaken out and “the game” the Fed is playing is no longer a confidence game, but instead is the kind of transparent, well-supervised marketplace that’s the hallmark of capitalism.

Source: Inside Wall Street: The Real Reason the Federal Reserve Can’t Raise Interest Rates

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