Event Horizon

There are some absolutely fascinating dynamics at work in the global economy right now.

Today, the stock market rose sharply after the Federal Reserve released the minutes from its December meeting, and investors interpreted those minutes to indicate that interest rate hikes are nearing an end. But something else also happened today. The Federal Reserve increased its level of temporary liquidity to the highest level since 9/11. For those not familiar with the term, liquidity is essentially money created by the Federal Reserve that acts to support various assets such as stocks, bonds and commodities. Today, that pool of liquidity reached a stunning $60 billion, up from $23 billion in mid-December. To be sure, the Fed boosts liquidity at the end of every year, but size of this increase is extraordinary and far greater than any previous year-end.

As a result, both oil and gold rallied sharply as well. As I type this, oil is at $63, and gold is up $20 from its close on Friday. Oil and gold (and stocks, of course) are reflecting the incredible amount of liquidity that's been created during the past few weeks (and months/years, for that matter). Investors are watching the Federal Reserve's actions---creating a huge amount of money out of the blue, hinting that rate hikes are almost done---and realizing that the Fed has decided to follow only one course of action: inflate. The Fed's actions are utterly irresponsible. If the Fed was truly independent from political influence as is supposed to be the case, Alan Greenspan would be yanked onto the carpet before he retires in a few weeks and forced to explain himself. That won't happen, of course, so we should all expect to pay higher prices for everything we need. Did you think gas prices were high last summer? Wait until you see them this coming summer.

The Fed's actions have profound implications. From the early 1980's through the late 1990's, OPEC was willing to play ball with us; the U.S. could create enough liquidity to ameliorate economic weakness, and OPEC (particularly Saudi Arabia) would recycle its oil revenues into U.S. financial assets and take any action necessary to prevent the price of oil from rising. For various reasons---9/11, the war in Iraq alienating the Muslim world, the rise of players like Hugo Chavez---that relationship has completely broken down. Simply stated, OPEC is no longer willing to let us print our way out of messes; thus, the inexorable rise in the price of oil as the Federal Reserve continues to create a historic amount of paper and OPEC demands a higher price for its only natural resource. And instead of parking all those extra dollars in treasuries, the oil producers and other nations like China increasingly are snapping up gold to diversify away from the dollar and protect themselves.

To Washington, that's unacceptable. When China, Russia, Venezuela, Iran and Saudi Arabia refuse to play ball and start creating consequences for our profligate fiscal and monetary policy, that's when the gloves come off. Did you think the increasing speculation about military action against Iran is just about its nuclear program? Did you dismiss Russia's temporary halt in natural gas deliveries to Ukraine as a minor regional tiff? Have you been wondering why we seem so obsessed with someone like Hugo Chavez? Statists abhor consequences, and these nations are creating them for us. For any new readers, here's the link to a longer post I wrote about this important dynamic; I think understanding it is crucial, particularly regarding the issue of Iran.

For many months now, the Federal Reserve or its mouthpieces have hinted that the cycle of rate hikes is coming to an end. Keeping it somewhat open-ended is important, of course. If the Fed left absolutely no doubt that the cycle of rate hikes had ended, oil would shoot straight for $80 and gold for $600. Conversely, if the Fed made it clear (as it should) that it was concerned about inflation and that interest rates could possibly increase throughout most of 2006, the stock market and the economy would weaken right before the crucial mid-term elections and just as Bush's approval rating shows signs of recovering. That dynamic also applies to the burrs under our saddle. Want to take Chavez or Putin or the Mullahs down a notch? Stop printing so much money, and the price of oil---the source of their newfound influence and power---will back off. Or we can keep inflating to avoid unpleasant domestic consequences, and the event horizon draws ever closer. That's the box the Federal Reserve has created for itself, and for all of us.

In the past, we held the key to that box. Today, the keymasters are in Beijing, Moscow, Riyadh and Caracas---and most certainly Tehran. And that, of course, has profound geopolitical and military implications.