In my August 18th Briefing I said;

"I believe investors will continue to play a cat and mouse game with the Fed. On one hand, if a cut in the discount rate is good enough to cause a sustained rally in the stock market, the fed will have no incentive to lower rates for the consumer."

Today, there is no cat and mouse game, the market is up 145 points as we speak.

My argument is a very simple one. If the stock market continues to rally, the fed may take this as a sign that market confidence has improved, and there is no need to lower the fed funds rate for consumers.

Some argue that the 3 month Treasury bill rate is now below the fed funds target rate of 5.25%, concluding that the fed has no choice but to cut. I'm not so sure about that.

First of all, the sharp decline in the 3 month Treasury Yield was a knee-jerk reaction to fear. This extreme flight to quality was caused by investors fleeing the commercial paper market in fears that CDO's were ravaging every money market account known to man.

A few days before the fed came to the rescue of the credit markets, the fed declared that "inflation was the biggest risk to the economy". Has the inflation risk suddenly disappeared in a little over 30 days? I think not.

If the fed does in fact cut the fed funds rate at its September 18th meeting, inflation will continue to be a problem, and the US Dollar will continue to decline.

Since confidence in the markets has been restored, the fed may hold off until the next fed meeting before cutting the fed funds rate.

I say the next month because investors will not take the no interest rate cut very kindly. In fact, if the fed does not cut rates on September 18th, we may re-visit the August 13th lows (or lower).

If the fed does not begin cutting the fed funds rate, consumer spending will continue to erode, and the labor market will continue to soften. In any event, I don't think a 1% drop in the fed funds rate will be enough to ward off a recession.

Here why;

Consumers holding adjustable rate mortgages with a teaser rate of 3% are going to see those rates re-set at around 8%. If the fed lowers the discount rate 1%, holders of ARM's will see a reset of 7% on their mortgages. A 1% rate cut is hardly enough to bring us back to the heyday of wild consumer spending.

In conclusion, if the fed lowers rates the markets will celebrate, and then sell off. If the fed doesn't lower rates the market will sell-off. After the sell-off in both scenarios plays out, I am expecting a rally into year-end. 2008 could be the year we begin a recession.