When Fed officials warn of the dangers of “deflation” the assumption
is that they are referring to “falling consumer prices.” However,
Fed officials know that there is no “danger” of consumer prices actually
falling and even if it were to occur, such a development would be beneficial
for the economy. What Fed officials are really worried about is falling asset
prices; stocks, bonds, and real estate. The mal-invested, savings-short, U.S.
economy is only “viable” so long as the Fed can keep asset prices
rising. To do that the Fed needs to continuously make more credit available
at lower rates.

As a result, the Fed’s planned interest rate decision this Wednesday will
be based purely on a desire to blow additional air into the various asset bubbles
that it is currently nurturing. Since recent expectations have been lowered
for a 50 basis point cut, the Fed probably believes that it can get a positive
market reaction to what is now a larger than anticipated rate cut. The only
reason that they may not cut by 50 basis points is because such a cut puts
them 25 basis points closer to zero. However, even at 75 basis points, there
is still room for 2 more 25 basis point cuts, followed by a 10 basis point
cut and two 5 basis point cuts, leaving rates at 0.05. It remains to be seen
if the markets will allow the Fed to get away with such cuts, but there is
no doubt in my mind that the Fed will try.

The main reason that massive U.S. debt levels appear manageable is because
low interest rates temporarily reduce the cost of serving that debt while simultaneously
inflating the asset values against which that debt is being measured. If interest
rates were to triple, and asset prices cut in half, what appears now to be
a manageable situation would be exposed as a looming disaster. Although such
dramatic movements in rates and asset values are not necessary to create a
problem, the reality is that the actual movements will likely be even more
substantial. That is because rising interest rates themselves will depress
asset values and falling asset values will in turn cause interest rates to
rise (higher rates increase the cost of purchasing assets while higher debt
service costs result in more assets needing to be sold). As asset values fall,
loan collateral is destroyed, reducing the availability of credit, causing
interest rates to rise further.

It is this inevitable self-perpetuating spiral of falling asset prices and
loan defaults that the Fed fears. The irony of the situation is that the more
credit the Fed “creates” to keep the bubbles inflating, the more
air that will ultimately have to be let out. It is my opinion however, that
rather than attempting to deflate these bubbles, the Fed will ultimately blow
so much air into them that they simply explode, destroying the value of the
dollar, and sending consumer prices into the stratosphere.