Rate Cuts Will Make Inflation Problem Worse

"Turbulence" is the best word to describe the wild ride global markets have been on for the last two months, triggered by panic in subprime lending. And the Federal Reserve is right at the center of the turbulence — especially next week, when the FOMC meets to decide whether to cut interest rates.

Current Fed chair Ben Bernanke must wish all he had to worry about was promoting a book. He has to make the tough call here, about whether the US economy is faltering sufficiently to justify lowering interest rates when they are already actually pretty low. Adjusted for inflation, there hasn't been any time in the last 30 years when the Fed has started on a rate-cutting cycle when interest rates adjusted for inflation were as low as they are today.

And while markets are gripped with panic — especially more speculative credit markets — there really aren't all that many concrete signs that the economy is weakening. Okay, there was one soft jobs report last week. But that's pretty much it, and it is flatly contradicted by other employment indicators, such as the weekly jobless claims reports. And the unemployment rate remains a very robust 4.6%.

Sure, there are people who imagine that housing prices are going to fall 20%, and that wouldn't be pretty. But that's just a possibility for the future. In reality, the economy appears to be doing quite well by almost all indicators.

Yet the panic is a reality, too. And after a while, whether or not the panic is really justified, it becomes a self-fulfilling prophecy. We may be looking at a situation in which the economy will fall into recession for no better reason than because people fear that it will.

So what's Bernanke to do? Cut rates just because a bunch of bond traders are panicking, when there's no real sign of economic weakness? Yes, that's probably exactly what he's going to do.

Alan Greenspan, on the other hand, gets to spend next week on the talk-show circuit.

It would be all too easy for Greenspan to play the role of the omniscient and omnipotent monetary guru, and make it seem as though he would know exactly what to do in today's difficult environment. But so far, it looks like he is taking the high road and being quite honest and forthcoming about his own blind-spots and poor decisions.

For example, this Sunday night he will be interviewed on CBS's "Sixty Minutes," and reportedly will confess that he completely missed the risk of subprime lending. Greenspan told CBS, "While I was aware a lot of these practices were going on, I had no notion of how significant they had become until very late. I really didn't get it until very late in 2005 and 2006."

And Greenspan doesn't pretend that, if he were still chairman of the Fed, he'd necessarily know what to do. Talking about the credit market crisis in 1998 in which he lowered interest rates three times, and is generally regarded as a hero for doing so, he says, "We were dealing in an environment back there where inflation was easing. We could have acted without the fear of stoking inflationary pressures. You can't do that anymore."

Exactly. As I wrote in this column last week, Bernanke isn't free to cut interest rates the way Greenspan did, because inflation is suddenly very much coming back to life. In the last several weeks, while the credit crisis has caused the market to expect a Fed rate cut, all the classic indicators of inflation have gone into the red zone.

Look at the price of oil. Last week I said it will be headed for $200 a barrel if Bernanke follows through on a series of rate cuts. Since then it's moved to new all-time historic highs above $80. Hey, the longest journey begins with a single step (especially when it's a journey down the slippery slope of inflation).

And last week, I said gold would go to $2000 an ounce. Not quite there yet, but we've now blown through $700, and are flirting with new 27-year highs.

Last week I didn't give a price target for the US dollar, but it's now moved to all-time lows against the euro, and against a trade-weighted basket of foreign currencies.

Let's remember that none of this is really new. It's a continuation of trends that began in 2002 and 2003 when the Fed slashed interest rates to absurdly low levels and held them there. The Fed made money so cheap and so plentiful, it was virtually inevitable that commodities like gold and oil would rise, and that the dollar would fall. And I predicted just that in this column many times over the intervening years.

And the housing bubble, including the craze for subprime lending, was part of the same package. When the Fed prints too much money, real estate values skyrocket as surely as the gold price does. And, at the same time, when the Fed prints too much money, it's especially easy for lenders to make loans — even to people who aren't really qualified for them.

So do you see what's happening here? The fact that the Fed kept interest rates too low for too long got us into this mess. And now the Fed is going to lower them again — to get us out of this mess. Drunkards, waking up the next morning after a binge, call that "hair of the dog." The Fed calls it monetary policy.

So while it's refreshing to hear Alan Greenspan admit that he doesn't know everything, it would be even more refreshing to hear him admit that blunders while he was Fed chair are what got us into the fix we are in today.

At this point, I just hope that Ben Bernanke learns from Greenspan's mistakes, whether or not he has confessed them. Here's hoping that next week the FOMC holds itself to just a 25 basis point cut, not the 50 basis point cut many people expect. And here's hoping that the Fed doesn't promise more to come.

If Bernanke can keep that discipline, the markets will continue to sort out the mess they're in right now. The healing has already begun. Let's not add an inflationary blow-out to our problems.

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