After yesterday's Fed announcement the stock market dropped sharply. Bond yields fell too and the dollar rose against the euro. All three responses indicate the expectation of an economic downturn which will result from a shortage of dollar liquidity. The Fed has so far failed to meet the increased demand for dollars which arises from the danger of widespread bank failures in Europe resulting from defaults on sovereign debts. I commented on this situation in this post a couple of weeks ago.
Please remember that a drop in bond yields now is a very bad thing for it shows that investors expect the economy to remain depressed for a long time to come. The goal of the Fed and of the European Central Bank (ECB) should be to satisfy the demand for dollar liquidity by permanently expanding their balances sheets via the purchase of long maturity assets. More importantly, the central banks must convince the markets that they intend to continue this policy until the growth of nominal GDP has at least reached its trend line of 5% annual growth.
So far both the Fed and the ECB have failed to do this largely for political reasons. Moreover, commercial bankers have great influence over both institutions and bankers are of a "liquidationist" bent almost to a man - they prefer depression to any risk whatsoever of inflation.
Sadly, I think the world economic crisis (and it is indeed a crisis) is playing as a "Greek" tragedy in slow motion. The players have doomed themselves to destruction because they are unwilling to break away from old patterns of thought.
Until the Fed and the ECB can convince markets that they are prepared to accommodate the increasing demand for dollar liquidity world wide stocks will remain in a bear market and the dollar will rally against the euro as well as against other currencies.
