Say Two: Fed Loathe to Allow Inflationary Spiral, Lenders Tending Toward Caution

Despite drought and extra hot temperatures in Utah this summer, I am still trying to keep somewhat current. Today I'd like to point to two benchmark 'calls' that may prove very important going forward. The first is by Jim Hamilton, at Econbrowser who recently concluded that "… the truth is pretty simple-- the Fed now does have a very good understanding of inflation, and is not going to tolerate a resurgence." The second is by Yves Smith at naked capitalism who tells us that "The bear credit market has begun."

More from Smith's Has the Credit Contraction Finally Begun?:

Readers of this blog know that I have been concerned about the state of the credit markets for some time. We've had (until the last month or so), rampant liquidity feeding asset bubbles in virtually every asset class except the dollar and the yen, tight risk spreads (that means inadequate compensation for risk assumption), lax lending standards (that helped create the aforementioned bubbles), and increasing inflation pressures.

Now what inevitably happens when credit gets too cheap is that borrowers go and buy stupid things, like housing they can't afford or illiquid faith-based paper or overpriced companies, and at some point enough of this speculation, um, investment, turns out badly that lenders get nervous and start turning off the liquidity spigot. And the wilder the party has gotten, the worse the hangover.

Now heretofore, I have merely fulminated about this situation, because at some point, the correction will begin. But it's very easy for people like me to expect things to get rational way before they do (look how long the 1980s LBO wave, the Japan bubble, and the dot com mania lasted).

So as much as I have felt for a long time that these conditions were not sustainable, and were likely to end badly, I have refrained from making a call. Smarter people than me, like Martin Wolf of the Financial Times, have similarly pointed out that the global equity markets are considerably overvalued and are certain to mean-revert, but he pointedly refused to say the markets were near a peak.

But the few times I've made a specific investment call (and it's been very few times, believe me), I've been proven correct. So as a mater of public service (and doubtless ego as well), I'm making one now.

The bear credit market has begun.

… [T]he real news [is] the fact that the rating agencies have finally gotten religion and are going to start going through [financial] instruments with a much more jaundiced view. Mind you, they've started with subprimes, but they will get around to CDOs, so this is the beginning of a long and painful process. And even if they are cautious and late to the game, this process is going to force more trading, and the price discovery is going to be very painful.

And most important is that Standard & Poors has announced it is changing its methodology (and we imagine Moodys and Fitch will have to follow). …

We will follow both, to see if they prove right. Earlier, 5/26/2005 we noted 'calls' that a "top" was close at hand for the housing market. Did we get that one right? I would be remiss not to note that here in Utah the housing market is still booming, or, arguably, is just now beginning to stall, but that is certainly not the case in much of California, in Chicago, New York, Washington DC, Florida, etc. where the "stall" ("fall"?) is well underway.

Will we be on target here?