Credit Contraction, Deleveraging and the Coming Interest Rate Cut

I'm going to get self-referential (reverential?) for a few paragraphs and then let you read one of the really smart market economists. This is important stuff for charting your course over the next weeks and months. A couple posts back I wrote:

The credit contraction we've seen and will see is massive. The credit card companies are already cutting limits, prime brokers are pulling in unused lines from hedge funds, upside down mortgages that have to be written off, it's in the Trillions, maybe tens of trillions. The Fed, the Treasury, the Bureau of Engraving can't reliquify as fast as we're contracting.

And referred to this comment on a MarketBeat post:

Gold is not a hedge against deflation.
That mistaken idea came about because someone looked at the performance of HM stock in the thirties, put two and two together and got 18.
When Roosevelt depreciated the dollar from $20.67/oz. to $35, HM caught a windfall, paying costs in depreciated dollars and receiving the new higher price for their product.
That said, the Fed is a one trick pony. The only way out of the multi-trillion dollar debt contraction we’re looking at is to devalue the debt.
Gold will shine, but not until the deflationary phase is over.

Comment by Climateer - September 15, 2008 at 4:12 pm

MarketBeat came right back in their next post with some insight from Paul Kasriel, one of the best in the biz:

It was not until Sunday that the idea of the Federal Reserve actually reducing rates in the market Tuesday became a possibility. Now the market is depending on it, as futures markets are pricing in 100% odds that the slide-rule committee will lower rates at its meeting. And while Treasury Secretary Henry Paulson may feel confident enough in letting Lehman Brothers fail because of the academic definition of moral hazard, the Federal Reserve’s hawkish types will have to put their ideology on hold, says Paul Kasriel, chief U.S. economist at Northern Trust. “Consumer inflation cannot continue to increase without credit creation,” he writes. “Because of deflation in the price of assets, credit is now being constrained. And the constraint in the creation of credit is about to reduce the rate of consumer price inflation.” Various market spreads, such as the TED spread, short-dated notes, and the federal-funds futures market, all suggest the Fed will take action, and that it should. “Recent events suggest a large deleveraging of the banking system is picking up steam and suggests the risks to the economy are entirely concentrated in the growth outlook,” writes David Rosenberg, chief North American economist at Merrill Lynch. He believes the Fed will lower rates by a half-percentage point Tuesday.

The bolding was by Mr. Gaffen at MB. The italics were mine. Just to hammer the point home.