BEST OF ROBERT PRECHTER

By Robert Prechter, Steve Hochberg and Pete Kendall

December 19, 2007

A Mystery: If Money is Loose, Why Are the Debt Markets in Distress?

Is money tight or loose? Most people would laugh at this question and say that, with the Fed being so "accommodating," money is obviously loose. But that is not my view. The Fed has always followed the T-bill rate when setting its discount rate and Fed funds target. From its February 2007 high, the U.S. T-bill rate has fallen 2.33 percent, but the Fed has lowered rates only one percent. Aside from the lower rates in its new repo auction scheme, it is still charging more than a full point above the T-bill rate, which is more than it normally would charge for its loans. The reasons are instructive.

The first reason for the slow rate reduction is that professional and public opinion is angry at the Fed for having fostered, through its role as lender of last resort, the bubble of loose money that supported the real estate mania and its sour resolution. So the Fed has decided that it wants to appear conservative and responsible by lowering rates slowly, even though the market rate for T-bills calls for a faster reduction. In other words, the Fed is sensitive to criticism and is therefore subject to outside opinions. This is not the way monetary engineering is supposed to work, is it? The public’s emotions and opinions are not supposed to affect its decisions. But they do. That’s just one of the problems with monetarism.

The second reason for the slow rate reduction is that inflation has raged up to this point, so many among the Fed’s governors, quite naturally, fear inflation. But past and future trends are two different things. Inflation has raged, but deflation is next. Yet it takes a historian, not an economist, to see it coming. The Fed, then, is reacting to the past. Today’s announcement of the biggest monthly jump in the Consumer Price Index in over two years is the kind of news that fans inflation fears even after they are no longer valid. The CPI lags all other indicators of inflation. To make policy based on the CPI is to be behind the curve. Home prices are already falling, and if the U.S. dollar and precious metals have reversed trend, they will be leading indicators of the real problem: deflation. So the Fed is basing its conservatism on old news, keeping money tight and not realizing that it is doing so.

But hey, I’m all for it. Whatever hastens the debt implosion so we can get past it and – one would hope – rebuild a valid (i.e. free market) monetary system is welcome.

This article is an excerpt from The Elliott Wave Theorist and/or The Elliott Wave Financial Forecast monthly newsletters. Get the very latest analysis from Robert Prechter’s Elliott Wave International. www.elliottwave.com/a.asp?url=http://www.elliottwave.com&cn=ir