The Fed's Grade: 'A.'

Many things have happened since that incredible day when the Fed acted.

There are a few things I'd like to say about the Fed action. Many believe that the Fed is bending over to Wall Street. People in this camp believe that the Fed has one job - to control inflation - and that if the major financial market indices show a weakening economy, the Fed should not take note. Tuesday morning's action was clearly a Fed reacting to the global financial markets.

The Jayhawk believes that is not only okay, it is good. It is vital. It is important and it is crucial for the Fed to listen to the financial markets.

Why?

Let's go back to the reason the Fed was created.

The purpose and functions of the Federal Reserve include:

• to serve as the central bank for the United States
• to address banking panics
  
• to manage the nation's money supply through monetary policy
• fostering a sound banking system and a healthy economy
• facilitate the exchange of payments among regions
• strengthen U.S. standing in the world economy
• to be responsive to local liquidity needs
• to strike a balance between private interests of banks and the centralized responsibility of government

Additionally, let's consider the following facts:

1. The Fed is seen as the big daddy of the finance world. When it speaks, people listen. When it is silent, people listen more and listen harder.

2. The Fed's main goal is monetary policy *and* regulation. (As most of you know, I believe the Fed should focus more on the latter and let the markets dictate the former.) It is clear that monetary policy is great at controlling inflation, but it is not so clear that is is very good at stimulating a contracting economy. The phrase "pushing on a string" is often used in this regard to illustrate that monetary policy has defined limits to accelerating economic growth.

3. The year is 2008. In the US alone, $14 Trillion (that's right, with a 'T') is in mutual funds. An additional $12 Trillion is in pension funds. These figures do not include other investments vehicles such as hedge funds and individual stock portfolios - retirement or otherwise. The point is this: the US financial markets - not just the stock market - have become a savings account for the average American.

4. Today's dynamic financial markets today have a lot more information available to them and are very good at pricing in risk. The markets have been indicating - for several months - that the Fed ought lower its target rate.

When there is a global financial market sell-off after a severe correction like we've had, i.e. 15% in a few weeks, this creates worry and tension in the consumer's mind. Again, the reason is that this affects an unprecedented number of people in unimaginable ways. Moreoever, there is a very large population of 'baby-boomers' waiting to retire, whose life savings are in stocks.

The Fed's action in staving off a panic was necessary. It is clear that an additional 5 - 10% correction to the already 15% would be disasterous to the mindset of the American consumer. There would be rampant fear. Most people act irrationally with money anyway, so many would sell their stock holdings, which would only make the situation worse. With massive losses, consumers would be affected negatively and a potentially severe recession could ensue. Two-thirds of the US economy is consumer driven. We are already dealing with a housing recession - there is no need to make things worse just so that "we can get over it". We may never get over it for decades if the Fed doesn't act when it has to.

The Fed's decision to restore confidence in the markets was important. Additionally, the liquidity created will hopefully restore credit markets back to normal. All this takes time, but it will heal.

To those who are worried about inflation - read my earlier posts. Core inflation remains low. Today's inflation numbers are high primarily due to higher energy prices, i.e. cost-push inflation. The Fed does NOT control oil prices - lowering rates does not automatically cause inflation. It almost sounds like the anti-inflation hawks would rather see inflation at 1% and unemployment at 10% with negative GDP growth for years. Get over it! Once the economic expansion is under way again, the Fed can raise rates to fight whatever inflation exists at the time. After all, it's much easier to slow down the economy.

Take a look at Europe. The ECB has been stubborn about inflation and refuses to cut its target rate. Well, take a look at the GDP growth and unemployment figures of European countries - they're much worse than America's. So what if their currency is stronger right now? Would you rather have a super strong currency and high unemployment?

So, let's reconsider the Fed's goals and see if it met them or not in Tuesday's action:

1. To address banking panics - CHECK.
2. Fostering a sound banking system and a healthy economy - CHECK.
3. To be responsive to local liquidity needs - CHECK.

The bottom line: Bravo Ben, Bravo! The Fed acted correctly - it gets an A grade. Had it been sooner, I'd have awarded it an 'A+'.

What grade do you give the Fed?