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The Federal Reserve is simply not institutionally prepared for the unfolding challenging environment, although the same could be said for policymakers and the public generally. The Fed is left floundering in the shallowest of central banking doctrine, bereft of any substance as to the key underlying forces driving the economy, the markets and, increasingly, inflationary pressures. At the same time, the Fed’s benign neglect of Credit Bubble excesses is buttressed by the view from the White House to the Halls of Congress that domestic and international growth are the only avenues for rectifying imbalances. It’s quite dangerous dogma, yet the markets are happy to play along.  

The Bernanke Fed today plays a dangerous game of sheep in wolf’s clothing, talking tough on (“core”) inflation while praying it can stay soft on excess. Highly speculative marketplaces at home and abroad savor in the gamesmanship. Markets recognize that the Fed will now talk the talk when speculative excess pushes the envelope, although they remain confident that the Fed will obediently retreat when markets come under sufficient pressure. Participants simply wait patiently for a signal from the Fed – as they believe they received yesterday – and get right back to their business.  

I do read commentary that the Fed and global central bankers have been “withdrawing liquidity.” I don’t see it. For starters, the vast majority of global liquidity these days emanates from private-sector debt growth and securities leveraging. Keep in mind that Credit is growing at double-digit rates across the globe. The Federal Reserve’s balance sheet has become virtually irrelevant to the global liquidity-creation process, and the Fed has not been selling securities to reduce liquidity in the system (and they would have to sell a large amount today to offset record Credit growth!). For central banks to actually “tighten” policy would require an overall global rate environment sufficiently restrictive to induce private borrowing and leveraging restraint. I’m still waiting.

Doug Noland is a market strategist at Prudent Bear Funds. Their website is www.prudentbear.com.