Bonds Reassess Wisdom of Fed Neutrality

That said, and given the preceding gains, major averages performed admirably. The Dow Jones Industrial Average added 0.1% to close at 12,461.14, while the S&P 500 lost a fraction to close at 1434.54. The Nasdaq Composite slid 0.2% to close 2451.74.

Profit issues notwithstanding, the macroeconomic story dominated Thursday. Traders came to the realization that the Fed's shifting gears to neutral likely means "stuck in neutral," not "in neutral with the easy choice to slam on the breaks or hit the accelerator."

Fed Zigs, Treasuries Zag

In summary, the Fed simultaneously said in its statement Wednesday that it is very worried about inflation and that economic growth is slowing. By removing the notion that further "firming" may be at hand, the central bank implicitly agreed that the home price deflation problem occurring in the U.S. could spill into the broad economy. That kind of bleeding necessitates a breath of life into the system -- even though prices for most things besides homes are nowhere near deflating.

So a rate cut at the cost of higher inflation would only reignite the credit creation that fueled the housing bubble. And the central bank would likely end up with higher rates further down the road -- when the crisis is averted but inflation is higher. Voila, a Fed stuck in neutral.

"We have stagflation," says Paul Kasriel, chief U.S. economist at Northern Trust Co. of Chicago, who is concerned about the possibility of a recession. "We always have stagflation at this point in the cycle because inflation is a lagging indicator. We almost always see the economy slow down, and then we continue to see inflation move up a little bit."

Inflation eventually turns down if the economy continues to weaken, he says.