Bullets and The Gun

Since the massive liqudity injection post-9/11, I have said (when rates were around 1.5%) that the Fed was going to need to reflate the economy by putting "bullets" back in the "gun". This has occurred over the last 24 months, and this is what needed to happen, since there has simply been too much liquidity in the system, and this has led to excessive risk taking, and low risk premiums. Historically, an environment with low risk premiums fares very poorly, and the recent credit crisis shows why.

So why did I think way back when that the Fed needed to put more bullets in the gun? Because those "bullets" represent Fed flexibililty in the face of another economic emergency. If we had been stuck in the 1.5% range, in the face of another Black Swan event, the Fed wouldn't have much wiggle room to move downward, and we certainly wouldn't want to end up in a Japan-style conundrum of a .5% rate environment. So by ratcheting up rates over the last 24 months, the Fed soaked up some liquidity, which is a good thing, since as Milton Friedman always said "inflation is everywhere and always a monetary phenomenon".

The Fed's decision to lower rates yesterday by .25% (Fed funds and discount rate) was seen as too little too late. The market already expected .25%, and "wanted" a reduction of .5%. Over the next year, the market expects rates to be lower by another 1%, which would greatly help out struggling financials and consumers. So while the Fed has wisely loaded it's Monetary Gun with additional bullets over the last couple of years, it needs to be able to pull the trigger! These gradual reductions will lead to more uncertainty and may lead us to the brink of a recession if not diligently handled.