Field Marshal von Bernanke

"No battle plan survives initial contact with the enemy" Prussian Army chief of staff Helmuth Karl Bernhard Graf von Moltke famously said back in the 19th century (or words to that effect).

The best laid plans often have to be chucked to adapt to the changing dynamics of the battlefield (Ack! Where did that cavalry brigade attacking my left flank come from?). While an inability to react to changing circumstances can be a recipe for disaster, there's also a danger in overreacting to new -- and perhaps unreliable or incomplete -- information.

Battlefield generals call it "the fog of war." The need to fill in gaps in knowledge in the midst of a rapidly changing situation demands interpretation, analysis and action based on even the tiniest scraps of information. One solution is to delegate more authority to lieutenants in the field -- they are closer to the action and may be in a better position to make snap judgments.

By many accounts, that's been the style of generalship of Federal Reserve Chairman Ben Bernanke who, in contrast to his predecessor, Alan Greenspan, has made the Fed's decisions on monetary policy a more collaborative process.

Until this week, the Fed's Open Market Committee had been sticking to the battle plan it came up with last summer, when credit markets imploded over worries about losses in investments tied to mortgages and corporate debt. The plan has been to gradually reduce short term interest rates, 25 basis points at a time (or initially 50) at the committee's regularly scheduled meetings eight times a year, until the economy started to show signs of growth. A war of attrition, so to speak, against the malaise creeping from the housing downturn into the economy at large.

That all changed when European stocks went into a tailspin Monday. With American markets closed for the holiday, the Fed held an emergency meeting. The next morning the Fed unleashed an unscheduled, unprecedented 75-basis point cut in the federal funds and discount rates.

Stock market investors were cheered by the move, at least for a couple of days. But mortgage broker and syndicated columnist Lou Barnes -- who never ceases to be amazed at what he sees as the Fed's clueless response to the credit crunch -- warns again today that the decision to depart from a gradual reducton in short term rates may send long-term interest rates (including those on mortgages) in the other direction.

That's the last thing the economy needs right now, Barnes writes:

"A properly conducted Fed rescue must be delicate because rescue depends on lower long-term rates, not just the short-term ones that the Fed controls. Precedent is more important to the Fed than to the Supreme Court. If the Fed moves in stately, predictable and dignified fashion, long-term rates will follow, even though reversal one day is inevitable. This economy needs lower long-term rates than any in modern times."

Barnes, like many other observers, thinks Bernanke and his lieutenants on the Open Market Committee acted primarily to support the stock market -- to the long-term detriment of housing markets and the economy.

One worrisome theory is that the cause of Monday's sell-off in Europe was not some fundamental weakness in the economy, but a French bank's attempts to unwind billions in dollars in unauthorized investments made by a futures trader. The trader, Jerome Kerviel reportedly made $73 billion in investments -- about the annual GDP of Slovakia -- which cost France's second-biggest bank, Societe Generale, $7 billion. 

What's worrisome is that, according to a story in the Wall Street Journal, members of the Fed's Open Market Committee were unaware of SocGen's efforts to deal with the fraudulent investments when it made its decision to to cut rates. In other words, the Fed may have abandoned what Barnes describes as its "stately, predictable and dignified" short-term rate cuts largely because of the actions of a 31-year-old futures trader who is now a fugitive (for more, check out the discussion on The Big Picture)

A Fed official told the Journal that the decision was based on "cumulative evidence of downside risks to the economy, of which mounting volatility in the markets was a symptom."

But Barnes notes that other than Monday's panic in European stocks (and futures trading that correctly predicted the Dow Jones Industrial Average would open down more than 500 points Tuesday morning), there was no other obvious trigger for the Fed's action.

Looking back at the reaction to the Fed's decision, Barnes writes that "the first assumption was that it knew of some new credit disaster. Like a man after a car accident patting himself, looking for injury or blood, markets took inventory. Nothing. The only reason for the timing of the ease was to support the stock market... (Bernanke's) extreme action, unprecedented in the entire history of the Fed, was notably not joined by any other central bank."

In response to this "random, academic-in-a-china-shop behavior," Barnes concludes, the "already fragile and illiquid bond market raised rates and slowed trading."

Sigh. Lock in those low mortgage interest rates now?

If this is a war against economic instability, the stock market and the housing market are like allies whose interests sometimes clash, and who could become enemies at any moment -- something like the U.S. and Russia during World War II.

Now that the Fed has thrown out its original plan of battle, the big question is what it will do at its regularly scheduled meeting Jan. 29 and 30. Stock market investors are betting on another rate cut -- nothing less than 50 basis points will please some -- and if they don't get it, stocks will tank at the end of the month. If the Fed plays along and reduces short-term rates, that could put more upward pressure on long-term rates, including mortgages.

The only saving grace is that ultimately, "the economy drives rates, loopy Fed or no," Barnes writes. While the state of the economy is probably better than feared -- he thinks "Bubble Zone" housing prices could bottom out this year -- "this was the worst week for economic public policy in my memory." 

And this post hasn't even gotten into Barnes' views on the economic stimulus package, including proposal to raise the conforming loan limit. Check in here and join the discussion of that issue.

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