Fed Chief Cuts Rate, but at Expense of Inflation

I was wrong about Ben Bernanke and the Fed. I've been writing here for months that they wouldn't cut rates. I finally conceded they'd cut by 25 basis points. This week they did 50. (I think they did it just to torture me.) I was wrong. I admit it.

But I was right about the markets. Throughout the crisis of the last six weeks I've said that stocks would recover. They haven't made it all the way back to new all-time highs — yet. But they've made it within a couple percentage points, and everyone else said the world was coming to an end and stocks were going to zero.

And I was right that the Federal Reserve would fan the flames of inflation. Since the rate cut on Tuesday, all the indicators of inflation have moved into the red zone. Gold has moved to new cycle highs. Oil has moved to all-time highs. And the dollar has fallen to all-time lows.

You see, there's no such thing as a free bailout. The Fed rode to the rescue of the fractured credit markets, but the price will be paid for years by every one of us, every time we fill up our gas tanks.

To add insult to injury, it was all completely unnecessary.

The credit markets had substantially recovered long before the Fed cut rates on Tuesday. And other than one tepid jobs report, there hasn't been any real sign of any economic weakness.

All I can think is that when the Federal Open Market Committee gathered in their palatial Washington conference room on Tuesday, some horrible mass hysteria gripped these normally sober souls. They must have gone off the deep end of imagining worst-case scenarios for jobs, the housing market and consumers faced with higher mortgage-rate re-sets.

Or maybe they just got tired of all the phone calls from mortgage company CEOs lobbying for federal money to rescue them from their profoundly stupid lending spree of the last three years. Either way, the Fed caved. No two ways about it.

Let's put this thing in perspective. What has really gone so wrong that the Fed had to cut rates by a surprise 50 basis points, and set off the beginnings of an inflationary wave?

All that's gone wrong is that there are about $70 billion in subprime mortgage loans in foreclosure, and another $112 billion that are delinquent. Sounds like a lot of money to you and me. But the reality is that these numbers don't even register in the huge American economy. They round to zero. They don't matter.

Take a look at the chart at right. The big pyramid is the approximately $70 trillion in assets held by U.S. households — stocks, bonds, real estate, automobiles and so on. The little pyramid is the approximately $11 trillion in U.S. household debt.

At the top of the little pyramid is an even smaller pink pyramid. That's the approximately $1 trillion in subprime mortgage debt. The subprime mortgages that are in foreclosure or delinquency are the couple of pixels at the top of the pyramid in pink — you basically can't even see them.

Imagine the worst case. Say all the delinquent loans go into foreclosure. Then say that the lenders can't sell the houses they repossess, so they lose all that money totally. Multiply that by two, just for some wiggle room. We're talking less than $400 billion dollars for those lenders to lose — and that's the max, because those repossessed homes sure aren't worth zero.

Let's look at it from the homeowner's point of view. It's a tragedy to be thrown out of your house. But you just go back to renting. Life goes on. We're talking something like 200,000 to 300,000 people here. It's a lot, but really nothing in the grand scheme of things.

In terms of people and in terms of money, the subprime problem is about on a par with Hurricane Katrina. A tragedy to be sure, and an expensive mess. But it didn't throw the U.S. economy into recession, and the Fed didn't feel like it had to cut interest rates because of it.

So what about all the other massive losses that are constantly being reported in the financial press, triggered by the subprime panic? What about the leveraged hedge funds that lost billions in July? What about the alphabet soup of exotic financial instruments, the value of which and the markets for which have collapsed: CDOs, CLOs, SIVs and all the rest?

Those losses don't count, because they are "zero-sum games." In all cases, for every winner there is a loser. So there have been some big losers, but also just as many big winners.

So what's all the fuss about?

In my view, the fuss is simply that we've had easy money from the Fed for many years, and that led to crazy lending and even crazier speculation. It was bound to come unwound one way or another, and the scare about subprime delinquencies just happens to have been the news story that triggered the inevitable reckoning. If it hadn't been that, it would've been something else.

But we have a Fed that apparently doesn't have the stomach, or the political will, to let the chips fall where they may. By caving to pressure from Wall Street — and from some vocal members of Congress who seem to have forgotten that the Fed is supposed to be independent — our central bank has taken the easy way out.

In the short to intermediate run, everything will be fine. The economy won't go into recession. Stocks will make new all-time highs. The credit markets will start working again.

But they would have anyway, even if the Fed hadn't cut rates. So now that the Fed has made that mistake, the economy will grow a little faster — for a while. Stocks will go a little higher — for a while. The credit markets will recover a little sooner — for a while.

Then we'll have years of inflation, and eventually the Fed will have to jack up rates sky-high to deal with it.

How to play it? Buy stocks, but be ready to bail when the inflation threat gets so obvious the Fed will have to act. Want the best results? Buy gold. Buy gold stocks. Buy oil. Buy oil stocks. Sell the dollar, buy the euro. Buy stocks that get most of their earnings from overseas.

And maybe you should buy a couple of "Whip Inflation Now" buttons on eBay. I think they're coming back into style.

Donald Luskin is chief investment officer of Trend Macrolytics, an economics consulting firm serving institutional investors. You may contact him at don@trendmacro.com.