Liquidity Cycle

The Fed has tightened the growth of monetary liquidity for several
years. With the advent of the subprime mortgage and housing
debacle last year, the commercial paper market crashed to the tune
of $700 billion, sharply reducing the rate of credit driven liquidity
growth. Profit shrinkage generally follows hits to liquidity, and we
are seeing that, although the damage is primarily in the financial
sector. Economic slack has increased in the US and this usually sets
up a contraction of inflation. However, a strong global economy and
a weak US dollar stemming from cuts to the Fed Funds rate, did
keep the inflation pressure on an upswing until recently.

The commodities market -- the dominant inflation force -- has been
weakening in recent weeks, including the petroleum and gas markets.
Normally, once there has been a liquidity and profits recession that
results in a weakening of inflation, the Fed will relax the restraints
on the growth of monetary liquidity, and one can begin to look
forward to a stronger economy and a profits turnaround.

With slowing global growth, the Fed needs to assess carefully whether
enough slack will develop to underwrite further weakness in
commodities prices which would "green light" the Bank to allow
faster growth of its portfolio and the monetary base. The Fed has
been badly stung by the commodities boom of the past year, and has
been extremely tentative in providing liquidity to the system overall.
The Fed also knows that if it holds rates steady as inflation recedes,
the dollar may strengthen further, giving them another leg up on the
commodities market.

It naturally remains to be seen whether this liquidity cycle blueprint
develops as usual. For now, the pieces are starting to fall in place,
although the Fed remains very tentative, as it is hard to relax after
such a daunting and powerful run in the commodities market. The
latter has greatly inhibited the Fed in its liquidity provision
decisions, and has also punished business, consumer and investor
confidence.