31/03/2010 – You Still Believe The Fed Can Stop Deflation?

The excerpt you are about to read is from EWI president
Robert Prechter’s October 19, 2007, Elliott Wave Theorist.
If you find it insightful, read more of Bob’s writings
in the free Club EWI resource, “Robert Prechter’s
Most Important Writings on Deflation.” (Details
below.)

You cannot pick up a newspaper, turn on financial TV
or read an economist’s report without hearing that the
Fed’s latest discount-rate cut is bullish because
it indicates the Fed’s decision to “pump liquidity” into
the system. This opinion is so completely wrong that
it is hard to believe its ubiquity.

First of all, the Fed does not “decide” where
it wants interest rates. All it does is follow the market.
Figure 17 proves it. Wherever the T-bill rate goes, the
Fed’s “target rate” for federal funds
immediately follows. That’s all there is to it.

If you refuse to believe your eyes, then listen to the
chairman; Alan Greenspan is very clear on this point.
On September 17, a commentator on CNBC asked, “Did you
keep the interest rates too low for too long in 2002-2003?” Greenspan
immediately responded, “The market did.” Rates
were not “too low” or the period “too
long,” either, because the market, not the Fed,
made the decision on the level and the time, and the
market is never wrong; it is what it is. If investors
in trillions of dollars worth of U.S. Treasury debt worldwide
had demanded higher interest, they would have gotten
it, period.

Second, falling interest rates are almost never bullish.
All you have to do to understand this point is look at
Figure 18.

Interest rates fell persistently through three of the
greatest bear markets in history: 1929-1932 in the Dow,
1990-2003 in the Japanese Nikkei, and 2000-2002 in the
NASDAQ. The only comparably deep bear market in the past
80 years in which interest rates rose took place in the
1970s when the Value Line index dropped 74%. Economists
all draw upon this experience, but they ignore the others.
Today’s environment of extensive investment leverage
and an Everest of debt in the banking system is far more
like 1929 in the U.S. and 1989 in Japan than it is like
the 1970s. Why is a decline in interest rates bearish
in such an environment? Because it means a decline in
the demand for credit. When people want less of something,
the price goes down.

The recent drop in rates indicates less borrowing, which
means that the primary prop under investment prices —
the expansion of credit — is weakening. That’s one
reason why stock prices fell in 2000-2002 and why they
are vulnerable now. This is the opposite of “pumping
liquidity”; it’s a slackening in liquidity.