The Market's Fate Lies in Fed Hands

From Conundrum to Dilemma

We can see from the previous chart how the post-Sept. 11 financial markets were able to ignore the effects of higher crude oil prices and how many of the real gains occurred not during the Federal Reserve's grand experiment in lower rates, but after it began to raise rates in a steady, predictable and resolute manner.

Katrina represents an enormous shock to the U.S. economy, and given the precedents of the Chicago Fire of 1871 and San Francisco earthquake and fire of 1906 contributing to the Panics of 1873 and 1907, respectively, we can say the costs of rebuilding the Gulf Coast in general and New Orleans in particular will weigh on the integrity of the banking system. The Federal Reserve, which was born out of the Panic of 1907, knows its first responsibility is to be a lender of last resort to the nation's banks.

The market concluded last week that the Federal Reserve would reverse course, ease, and worry about the consequences later. Katrina is a disaster of the first order, and as the military adage goes, no battle plans ever survive contact with the enemy.

If the Federal Reserve pretends nothing changed last week, it risks a credit crunch. If it eases, we can expect a continuation of the rising inflationary expectations, falling dollar, higher credit spreads and steeper yield curve we saw last week. The ultimate course for the stock market will be determined by these other variables and by an ongoing assessment of Katrina's total damage.

Fed Chairman Alan Greenspan had only five months left in his term, and may have been perfectly content to keep the rate hikes on autopilot and accept his valedictories. This final component of his legacy may be his most important.