Instead of pumping up the bubble it wanted…the Fed pumped up a bubble with a chip on its shoulder. A higher oil price doesn’t have the same agreeable effects as a higher house price. As we explained yesterday, we now have a group of “crude oil vigilantes” who race to buy oil in response to the Fed’s loose money policies. Then, higher priced energy hits the economy like an exterminating devil…it drives up prices for everything, effectively preventing the Fed from further inflating.

That’s what that headline in the FT is about; investors are betting that the Fed is going to change course…that with the economy still growing, it is going over to the other side…that it is going to turn its guns on inflation, rather than deflation.

There are three “vicious cycles” that the U.S. economy must face, former treasury secretary Larry Summers told the Financial Times . The first is a liquidity cycle, a kind of wash cycle in which unreasonably high asset prices are laundered out of the system… People are forced to sell…thereby sending prices down further. The second is a “Keynesian cycle,” in which a slump in the economy rinses out the habits of the bubble period. People begin to spend less…and save more. This, in turn, gives rise to the spin cycle – where, as we imagine it, people get dizzy and depressed because their incomes are going down; they can’t borrow; their costs are rising; and they’re getting poorer.

Where are we in these cycles? Probably only at the middle of the first cycle. Housing and finance have gone down. They probably have further to go. We have seen a foreshadowing of the second cycle too – people are not spending as freely as they did 18 months ago; consumer confidence is falling.

But wait…we’re not finished…

If the Fed really is going to reverse course and begin raising rates, we need to ask some questions:

Aren’t the bubbles in oil, commodities and gold going to pop?

Isn’t our Trade of the Decade (long gold, short stocks) going to go bad?

And how about the dollar? When Volcker came in and raised rates in the early ’80s, the dollar rose to a new high…while gold went into a 20-year bear market.

We remember those years.

“We have been a gold bug for the last 28 years,” we told a fund manager recently. “Only the last 8 of those years have been happy ones.”

Are we gold bugs doomed to another two decades of misery?

Anything is possible, of course. But we don’t see anything like the situation that greeted Paul Volcker in the late ’70s…and we don’t see anyone like Paul Volcker at the Fed either.

Be sure you are aware, dear reader, of what is headed our way. You can still protect yourself and your assets – while building your portfolio at the same time. The key is to invest wisely…in things that actually benefit from a market downturn. Strategic Investment has pinpointed those areas, and they are all available to you in the Strategic Financial Library .

*** And speaking of former Fed chiefs, we mentioned that Short Fuse and Addison met the Maestro himself this past Wednesday, to interview him for I.O.U.S.A.

“Is it fair to say that Fed policy has had a dramatic impact on the nation’s savings rate?” was one of the things they wanted to pick Greenspan’s brain about.

“We paraphrase the rest of his response from memory,” says Addison. “In an era of low interest rates, the nation’s savings rate has been abnormally low, as well. Rather than save a portion of their incomes at low interest rates, Americans have opted to divert a portion of their income into their 401(k)s and homes. As capital gains from these two assets classes slow down, Dr. Greenspan expects the traditional “savings rate” to tick back up… as a larger portion of incomes are diverted back into savings accounts.

“He added, in the face of the dire fiscal policy of the federal government, there’s only so much monetary policy can do to shore up the currency in which people are trying to save.”

While Dr. Greenspan’s time was very tight Wednesday morning, he gave the film team an extra ten minutes – and even posed for a picture. Right away, we noticed some similarities between this photo and a TIME magazine cover. What do you think?

Short Fuse and Addison assure us there will be more to come from this interview. Stay tuned.

Source: The Wrong Kind of Bubbles

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