Weekly Wrap

One-armed economists are in short supply, as President Harry Truman ruefully observed. When prognosticating, economists typically hedge their bets. On the one hand, they begin, before eventually backtracking. But then, on the other hand....

Drove Truman crazy. Notice in the photo above that Fed Chairman Ben Bernanke is using both hands, and with good reason. He remains unsure which way the U.S. economy is heading. Anticipating a weak, protracted recovery, Bernanke has signalled that interest rates will remain low for "an extended period." On the other hand, the Federal Reserve announced last night that it was raising its discount rate a quarter of a percentage point to 0.75%. The discount rate is the interest charged by the Fed, as lender of last resort, to banks needing quick cash.

Technically, this move does not amount to a tightening. The federal funds rate, the rate at which one bank lends funds deposited at the Fed to another bank, remains at 0.25%. The Fed used to keep the spread between the two rates at a full percentage point, but that spread was compressed during the credit-market turmoil of late 2008. With the spread now widening, does Bernanke think that things are getting back to normal?

If he does, hit-and-run trader Jeff Cooper thinks the opposite. The recent tranquillity in the financial markets may be just the calm before the storm. "If the 2008 global meltdown was not just bad subprime loans going belly up," says Coops, "but [instead] a warning sign that the entire world financial structure was overextended and about to unravel, then this is the eye of the hurricane." The widespread concern this week about the sovereign debts of the so-called PIGS may be the first freshening breezes of the back side of the storm.

Whether or not he himself sees the storm coming, Bernanke may be responding to public pressure to rein in the big banks on Wall Street. "Remember," Cooper reminds us, "the Fed isn't a federal agency at all but a cartel of big banks that does the bidding of big banks." And those big banks have been coining money under the Fed's Zero Interest Rate Policy (ZIRP), borrowing low and lending high. But continued high unemployment and credit contraction show that the "flow" is not making it to the real economy. As Christopher Whalen of Institutional Risk Analytics explains, "to date the entire focus of Fed policy efforts [including quantitative easing] has been to temporarily spare the largest dealer banks from losses on securities and not helping the real economy."

Whalen believes that gradually rising interest rates will actually help the economy. "In a fiat money system, ZIRP implies that paper assets have no value. If the Fed wants to break the deflationary cycle that now threatens the global economy and truly restore investor confidence, then it is time to let interest rates start to rise." But there will be losers. The price discovery accompanying higher rates will negatively impact the holders of all those toxic mortgage-backed securities, including the Fed itself, which brought a trillion or two dollars worth of said MBS onto its own balance sheet.

Maybe, in that picture above, Bernanke is weighing his choices. On the one hand, he could save the banksters. Or, on the other hand, he could take the shackles off the broad economy. Let's hope he makes the right choice.