Stealthy inflation...

The Fed seems to have changed its discourse of late and the markets seem to be pricing this in. Bernanke's rhetoric has shifted from coming to the rescue in the event of a slowdown to intervention even if there is no slowdown, and part of the problem may reside with an over reliance on core inflation figures, an indicator that may not be showing the full picture with regards to inflation. Over the past decade, for example, headline inflation, which includes both food and energy, remained substantially above core inflation. Had the bull period continued for a while longer, core inflation may have headed in the same direction as headline and there were already signs of this happening just before the sub prime market blew up.

The Fed's argument for relying on core figures is twofold. They not only see both food and energy as just noise but they also don't feel there is much that can be done to control them in any case. Currently both food and energy prices have been soaring which begs the question as to whether inflation may be around the corner and that it may be just a question of time before it rears its ugly head to an unprepared Fed.

Stuck in a quicksand...

Intervention is sometimes a necessary evil, particular in situations where doing nothing can risk creating a major meltdown in the financial systems. This was exactly the consequences of the "laissez-faire" approach that preceded the great depression of the 1930's. In a similar way, when the sub-prime market collapsed, it didn't take long to realize that the stakes where just too large to do nothing or very little about it. The longer term costs of maintaining the financial system on life support is manifold. For one, it will undoubtedly raise the risk of "moral hazard", particularly with regards to the "too big to fail" group and there is no real solution to this. Another risk that is more specific to the current crisis, however, is the long term negative impact on growth. The amount of liquidity injection and debt accumulation by the various government agencies across developed markets are unprecedented but what really seems to make the situation somewhat unique with respect to comparable situations in the past is that there doesn’t seem to be any effective exit strategies in sight. Confidence is low, unemployment is high, savings are virtually non-existent and leverage is still sky high. To make matters worse, most of the new debt is in relatively short term maturities (3 to 5 years) which kills any prospect of a vigorous fiscal stimulus plan taking hold.
Emerging markets that are structurally in much better shape may offer some degree of hope but this is very limited. At best we could hope for a partial decoupling from the toxicity of developed markets, it is hard to imagine anything else let alone how a market of roughly 2 trillion dollars in consumption (China and India combined) could possibly pull a market of 10 trillion dollars (U.S.) out of its current slump.
So although the latest economic figures are signalling growth, the economies of developed markets find themselves in a sort of quicksand where time is of essence. But this is quicksand and it is a delicate fine tuning balance between doing too much (fostering an environment that is conducive to organic "rotting") and not enough (raising the risks of a double dip recession). In either case, things could turn ugly.