The FOMC on Wednesday

The FOMC meets on Wednesday and most analysts are predicting nothing, in other words they don’t have a clue as to what Bernanke and Co will do. Most are playing the waters safe and saying that the Fed will hold and analyze whether supply side pressures have increased inflationary expectations. In English they want to know whether high oil and food prices have spilled over into consumer goods. Since oils increase companies have become very efficient and been able to absorb the cost increases. The cost cutting efforts have reached a limit and more capital accumulation, job cuts, or just in time manufacturing won’t improve the profit margin. The only recourse is to pass input price increases onto consumers. What does the Fed do, they raise interest rates in order to curb inflationary expectations. Now the longer the Fed waits the more prolonged the resulting recession will be. The last supply side shock resulted in three years of 10-15 percent interest rates. If the FOMC doesn’t get on the ball then the long run affects could be disastrous.

When constructing policy the Fed may use the Taylor rule. It has guided policy makers for the past two decades and is credited with keeping inflation in check. Now with inflation being the first subject of any Central Bankers speech we may be playing a game of chicken. In this arena game theorists abound and if you use game theory 101 a rationale decision maker would expect the Fed to talk hard and secretly hope for prices to fall by divine intervention. The likely hood of this happening is very low; sooner or later an interest rate hike will occur. Raising interest rates is the only solution to inflation. The increase of the Fed funds rates can influences long term rates and as a consequence investment decisions. Businesses borrow at long term rates and the difference between the Fed funds rate and the long term rate reflects the credibility of the Fed. For these reasons investors, psychologists, and random economists take time to analyze the speech that follows the FOMC meetings. If the sentence begins with inflationary pressures the dollar will rally because the FOMC is viewed as Hawkish. If Bernanke addresses the affects of the credit crunch on the economy look for the dollar to tank, because the FOMC is perceived to be Dovish.

Denial is one of those psychological blocks that can ruin a trader, like changing a stop because the trend will reverse. A cardinal rule of traders is don’t do it. This applies to Central bankers as well. Divine intervention will not occur; the Fed should stop hoping and step to the plate and increase interest rates. Yes the decision will make the Dow and the Nasdaq lose 2 percent in one day. However this is the consequence of our twenty year economic boom. A correction is needed and the Fed will be seen as the catalyst when any game theorist could have predicted the outcome. Either this meeting or the next the Fed will raise rates. In my opinion the sooner the better because procrastination makes the hangover last a lot longer.