Do the Right Thing Mr. Bernake

I am an optimist at heart. I am also a bull at heart. But I am also able to change with the times. Today and for the unforseeable future, I am a bear. Tomorrow at 2:15 PM EST, FOMC will release their policy statement. Many pundits conclude that it is a foregone conclusion that the FED will remain steady with their interest rate at 5.25%. What will be listend to closely tomorrow is the "language" of the FOMC. Many economists and equities players want to hear a "dovish" FED statements tomorrow that will hopefully signal the end of the tightening bias of the FED. What will be most closely watched is if there is any indication that the interest rates will be cut in the near future.

The markets rallied for the past two days based on the premise that the FED will hold the interest rates steady and that the language of the policy statement will reflect a change in tone to a dovish stance which would further invigorate the market. Many are clamoring or worse, begging for a rate cut. Some have even gone as far as to predict that an interest rate cut will come as early as May. Because deep down at the core of the majority of the market's wishes is to keep the market rally going. No one wants the party to end. But sadly, like all good things, all things must have a beginning and an end.

The specter of recession looms large. We have seen the first early warning shots that our economy is not all right from the recent subprime melt down. Many would want the FED to step in, play the role of a good guy, and "save" the markets from the recent "turmoil". That would include a dovish statement from the FED, indication that tightening bias is done, and a wink and a nod that the rate cuts are near. That wishful thinking is erroneous.

First thing that everyone needs to understand is that the tightening bias of the FED that began June 2004 that brought the current rates up to 5.25% was implemented to ease the housing bubble that was looming large. The effect was to tighten the credit availability to cool the economy. The FOMC policy of easing interest rates to combat the post 2001 dot com era melt down was artificially engineered to prop up the economy and to induce stimulus to the economy. That stimulus then created the next bubble that is housing. One must seriously consider that the rate hike campaign was to take the excess that existed in the housing and credit markets. Now that the pin has began to prick the subprime excess, many are calling for the FED to stop that they have done enough. If Ben Bernake and Co at FOMC are true to the policies set forth by Alan Greenspan, then they must continue to maintain the tightening bias because we are not done with fighting inflation.

FOMC must battle still high inflation risk versus saving the equity and housing market. The US economy is widely believed to be slowing down to 2-3% growth for 2007 and 2008. I think that the economy is cooling as expected by the FOMC and these measured rate hikes are not to blame for the possible recession that may take place. The easy credit and the go-go housing boom is not fully contained. FOMC must consider that the subprime pruge has not yet ended and that ALT-A Option ARMS pose significant risks to the economy. The interest rate policy of FOMC must be focused and true to their intended purpose. That is to fight inflation and to keep US economy growing at a reasonable rate. If FOMC does not heed their original intended plan, and give into the whims of the market or for political aims, this economy will falter into possible stagflation. Stagflation can be characterized by the 1970's where inflation was sky high and US economic growth was nil. That is exactly what the FOMC statement tomorrow has the potential to avoid or create.

What must be done in this economic environment is to reduce the excess liquidity from easy credit and high inflation. To do that, the FED must do the right thing by acknowledging that the inflation remains critical concern of the FOMC and that further policy will be dependent on the core inflation rates. As our recent PPI and CPI indicates, we are not there yet. Job growth and unemployment is still robust enough for the FOMC to stay in a tightening bias. It may be short term pain for the US economy if the FED resumes tightening the interest rates, but the prospect of a recession versus stagflation, should have the FED doing the right thing. That is to continue to let excess out of the subprime and prime mortgage markets. Acknowledge that the mortgage sector is in need of serious reform, purge the subprime and prime slime that infects our economy. Mr. Bernake has the rare opportunity to do the right thing that may not be seen as being too popular but for the welfare of the future of our economy, he must stay vigilant about fighting inflation, now more than ever. Otherwise, sadly, Mr. Bernake may go the way of Mr. Greenspan, who will trade one boom for another, and cause instability and pain in the American economy.

Mr. Bernake, do the right thing. I know you can do it. The right thing is always the hardest. If you stand for what you truly believe as an accomplished academic, please do the right thing.