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U.S. financial markets traded dazed and confused - understandably. For some time now, Wall Street has operated under a certain premise of how the Fed would respond to financial crisis. Recent expectations had our central bankers poised to lower rates to whatever level necessary to rekindle "animal spirits" and spur the Credit system and Wall Street risk intermediation more generally. The overriding presumption has been that inflation was a moot issue: inflationary pressures were well contained and, in any event, would rapidly dissipate in the face of housing, Credit and economic woes. This week the market came face-to-face with the reality that inflation is not only a major issue; inflation is in the process of significantly limiting the Fed’s flexibility and capacity to orchestrate another Wall Street bailout.

Markets boisterously protested the meagerness of the Fed’s 25 bps cuts in Fed Funds and the Discount Rate. Wednesday morning’s news of concerted global central bank unconventional liquidity injections garnered a curiously lukewarm reception. This was likely due to its limited scope as well as the recognition that such an approach indicated the Fed was exploring policy instruments outside of Greenspan-style zealous rate slashing. Many on Wall Street are calling the Fed’s handling of the situation a "fiasco," while some are even asking for Dr. Bernanke’s head. I would instead argue that unrealistic Wall Street expectations were once again instrumental in fostering marketplace instability.

There is certainly more than ample pontificating these days on the nuances of central banking. Meantime, there remains scant attention paid to underlying fundamental forces driving both the financial markets and monetary management. Last week’s Z.1 "flow of funds" data go far in illuminating today’s Market and Federal Reserve Dilemma: The enormous scope of Credit expansion necessary to sustain Wall Street’s bloated securities markets – to keep the contemporary Credit mechanisms generally liquid and functioning – has become patently inflationary for the system overall.

The third quarter demonstrated how, in spite of double-digit system Credit growth, an acutely fragile Credit system came to the brink of imploding. In particular, ongoing rampant Financial Sector expansion could not ameliorate revulsion to Wall Street-backed securitizations. Double-digit expansion in "money-like" debt instruments - including Treasuries, agencies debt, GSE MBS, and bank and money fund Deposits – had become powerless in providing liquidity support for Wall Street’s asset-backed commercial paper, CDO, ABS, and private-label (non-GSE guaranteed) MBS markets. Rapid expansion of Financial Market Credit (15.6% annualized!) was, at the same time, sufficient to adequately (over)finance the real economy, certainly including corporate cash-flows and household incomes and attendant ongoing massive Current Account Deficits.

Back in 2001/02, some Wall Street analysts (the "inflationists") were keen to argue that aggressive Fed reflationary policies were required to elevate "THE price level" to ensure that deflation was not allowed to take hold. Alluring, yes, but this was dangerously flawed reasoning. There was not and is not today an actual "price level" within the real economy to be manipulated by central banks. Instead, inflationary policies ensured that the interrelated operations of Wall Street’s asset-based lending, securitization, and leveraged securities speculation ballooned in unimaginable excess. Resulting Monetary Disorder saw wildly destabilizing price inflation and distortion, especially in housing, securities and asset markets generally. U.S. CPI may have remained tame, but massive Credit-induced Current Account Deficits and the depreciating dollar set in motion Credit and asset Bubble dynamics in economies around the globe.

Today, the Fed confronts bursting Credit Bubbles throughout Wall Street finance, with resulting acute asset market vulnerability. Yet the unusual structures that permeate the U.S. Financial Sector at this time foster continuing rampant inflationary Credit creation. First of all, "money-like" financial sector liabilities (i.e. agencies, "repos", and bank/money fund deposits) are proving thus far sufficient to sustain Bubble economy excesses. Second, the global recycling of ongoing massive Current Account Deficits and speculative outflows ensures over-liquefied markets (and artificially low interest rates!), including key U.S. debt instruments such as Treasuries, agencies and other perceived low-risk securities. Bubble dynamics proliferate in the face of a Wall Street bust.

The extreme divergence in liquidity conditions between bursting Bubbles in Wall Street finance and still rapidly inflating Bubbles in "money-like" Financial Sector Liabilities poses both a major quandary and policy dilemma. Aggressive rate cuts would definitely further stoke the powerful Bubbles inflating in GSE, "repo", money fund, and bank deposit liabilities. Such ongoing Financial Sector Debt expansion would likely sustain destabilizing liquidity outflows to the world, further fueling myriad global bubbles and worsening an already problematic global inflationary backdrop. A rapidly expanding U.S. Financial Sector (with the accompanying heavy risk intermediation burden associated with transforming highly risky loans into perceived safe liabilities) also significantly increases the risk of an eventual catastrophic breakdown in U.S. and international financial systems. Besides, it is likely that lower rates would have only minimal effect on the investor and speculator revulsion that has taken hold throughout the Wall Street securitization marketplace.

Those arguing for a Greenspan-style rate collapse fail to appreciate the extraordinary circumstances and risks that have accumulated from years of Reckless Credit Bubble Excess. The outcry for an audacious policy response to avert a recession is misguided. Importantly, today’s rampant Financial Sector expansion is unsustainable. There are today acute inflationary risks to go with major financial system stability issues. While the dislocation will be substantial, the sooner the Bubble in Financial Credit is reined in the better. We are today in the midst of dangerous "blow-off" excesses in "money-like" Financial Sector liability issuance. Few seem to appreciate that such a circumstance places the stability of the "bedrock" of the entire U.S. and global financial system at considerable risk. Wall Street is clamoring for a rate collapse and bold inflation in "money" to bailout its faltering securitization markets. At this point, this would equate to throwing massive (relatively) good "money" after bad - ensuring that a dreadful situation festers into a historic calamity. The least bad course for central bank policymaking would be to hold the line on rates, while injecting liquidity as necessary as part of a program to check Credit excess and permit the economy to commence its desperately needed adjustment period.

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