The Fed shows some backbone

Yesterday, the Federal Open Market Committee voted unanimously to hold their target funds rate unchanged at 2.00%.

Wall Street was urgently calling for yet another rate cut. Fed futures in the days leading up to yesterday's decision indicated a climbing percentage of bets that the rate would be cut by .25%, with an 88% probability indicated the day before the Fed's meeting. Many futures participants were even betting for a .50% rate cut.

Such a rate cut would have been in keeping with the volatile Fed policy that came to characterize the final years of the Greenspan Fed, as we have explained in greater detail in our August 22 posting, "The long shadow of the Y2K bug."

The howls of protest from some market pundits typifies the old Wall Street view that the Fed should jump to lower rates whenever it would serve their short-term interest.

That unhealthy pattern of giving Wall Street emergency cuts led directly to the severe turmoil wracking Wall Street this week -- events which have in fact just altered Wall Street as we have known it and probably ended the era of the big independent investment banks.

In light of that, it is a very positive sign that the Fed stood up to the demands for rate cuts and stood firm rather than cutting again.

The emergency cuts that started a year ago have not staved off the crisis that has engulfed AIG, Lehman, and others.* On the other hand, they have led to dramatically higher prices for businesses and consumers.

The CPI numbers continue to rise at an unacceptable rate. This week, the Bureau of Labor Statistics released August CPI data showing an increase of 5.4% over the index from a year ago. Many observers are acting as though the inflation threat has subsided, since the number shows a deceleration, mainly because gasoline prices came down significantly during the month of August, although the BLS report points out that gas prices are still up 35.6% from their August 2007 level.

But the "core" CPI, which excludes food and energy, is not only increasing but accelerating in its rate of increase. It's ironic that when the headline inflation number was going up more rapidly due to rising oil prices, inflation doves were pointing to the core CPI number that factors out food and energy. Now that the headline number is down but the core number is accelerating, the same voices are pointing to the headline number and ingnoring the core number!

In sum, the Fed did the right thing by refusing to lower rates again.

As for the rescue of AIG by the Federal Reserve late Tuesday, we are less enthusiastic. We can only point out that back in May we used that company in a post as a negative example in our discussion of why any doubts about the capability of the management of a company is a reason to avoid investment in the securities of that company.

* The principals of Taylor Frigon Capital Management do not own securities issued by AIG (AIG) or Lehman Brothers (LEH).

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