Fed Faces Credibility Crunch

As I said in a speech Tuesday night at a gathering of the Society for the Investigation of Recurring Events, or SIRE, there was too much liquidity in the world to suggest the Fed would cut rates even before Wednesday's CPI report. Junk-bond spreads are near all-time lows hit in 1997. M&A activity is running at 47% more by volume than it was in the same period of 2006. Risk appetite and animal spirits are alive and well in the markets.

That's why investors should perhaps have paid more attention to Fed Vice Chairman Donald Kohn's comments Wednesday in a speech at the Exchequer Club in Washington, D.C. Kohn warned of too much complacency in financial markets amid low interest rates and ample liquidity. Evidence of such complacency came Wednesday in markets' minimal reaction to the Bank of Japan's rate hike.

"In such a world, it would be imprudent to rule out sharp movements in asset prices and deterioration in market liquidity that would test the resiliency of market infrastructure and financial institutions," said Kohn. As a Greenspan confidante, Kohn's words may be more telling than the surface remarks reveal. Is he talking about the carry trade or the subprime housing market, which was roiled again Wednesday by NovaStar Financial (NFI Quote), or both?