Federal Reserve trapped in a box

March 17th, 2007

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Today, we saw this news report: U.S. stocks fall after inflation data, before Fed, which reported that ?Investors have been hoping that Fed, which meets next week, will soon cut rates to prevent a dry-up of liquidity in the financial system, as fears of a credit crunch were fueled by the meltdown of the subprime mortgage market.?

The Fed is in a quandary.

With the crisis in the sub-prime market, liquidity is what is badly needed in order to prevent a dangerous deflation of asset prices due to a credit-crunch. In layperson?s terms, this means ?printing? money to prevent mass bankruptcies in the economy. So far, the only tool at the Fed?s disposal to increase liquidity is to cut interest rates.

Unfortunately, the recent CPI data revealed price inflation pressures in the economy. Flooding the economy with even more money will exacerbate the problem of price inflation. Furthermore, the Fed has to preserve its reputation as inflation ?fighter? (the idea of the Fed ?fighting? inflation is ridiculous enough since it is the source of inflation in the first place?see Bloomberg: Fed?s Inflation Analysis Ranks With Zimbabwe?s). The difficulty with dealing with price inflation is that once expectation of inflation gets a foothold on to people?s mind, it will become the start of a slippery slope towards the loss of confidence in the nation?s fiat paper currency (hyperinflation is the symptom of ultimate loss of confidence). Therefore, there is pressure on the Fed to raise interest rates to ?fight? inflation.

What can the Fed do? We guess they will do nothing about interest rates in their next meeting.