That. Was. Unpleasant.

The rapidity with which confidence can shift is nothing short of a wonder of nature.  I am not sure there was any terribly new news today.  The evidence the US economy is weakening has been mounting for weeks.  That equities had not sold off yet was something of a testament to the underlying profit situation.

But now fear grips financial market participants as the rush to cash or cash equivalents accelerated.  A rush to judgment on the US economy?  Felix Salmon tries to paint a positive picture:

Firstly, this is not necessarily a Bad Thing. If you’re saving for retirement, stocks are cheaper now, and your 401(k) contribution goes further than it did a few weeks or months ago. That’s good.

Secondly, if there ever were serious doubts about the USA’s creditworthiness, they’re gone now. The 10-year bond is yielding less than 2.5%: there are no worries in evidence there.

Put those two things together, and you can even be quite happy about today’s sell-off. If you’re a debtor rather than a saver, then falling interest rates are good for you. If you want to buy a house, then falling mortgage rates — not to mention falling home prices — are also good news. And if you want to invest in some wonderful future income stream, then money’s cheap right now to do so.

This seems to me to be a point in the recovery where you do not want the 10-year Treasury plunging to 2.41 percent.  Felix offers a bit more pessimism:

Still, the future of the global economy is very uncertain, and southern Europe in particular is still far from any kind of sustainable resolution. The US economy has no particular exposure to Greece — but Italy is another matter entirely. This is a global sell-off, with European markets down just as much as those in the US; Asia’s sure to follow suit when it opens. Now that the Fed has stopped dropping dollar bills on the US economy, it’s hard to see where confidence and optimism are going to come from in the coming months.

Yes, will the Fed come to the rescue?  Ryan Avent:

The good news is this: the Fed can’t help but act. On Tuesday, I worried that the Fed would stand pat at its meeting next week, leaving the economy to dip into recession before it finally reacted in late August or following its September meeting. That no longer seems like the most likely outcome to me; events are moving too fast. Ben Bernanke may not announce a new policy next week, but I believe he will hint at new Fed easing—potentially at new purchases, but perhaps also at other available tools. The drop in inflation expectations should force the Fed’s hand.

Inflation expectations are coming down, with the 5 year TIPS measure less than 2 percent but the 10 year TIPS measure is still 2.23 percent (down just 4bp from yesterday).  Looking at the past week, I think Avent is on the right track – the Fed should be ready to get ahead of this mess, and next week is an opportune time.  That said, the Fed has tended to be late in the game throughout the past few years.  You have a lot of policymakers that need to fundamentally shift their intellectual framework to come to terms with a rapid shift in policy.  And they could easily point to the 10 year implied inflation expectation and say it need to fall further before we will act.  Same with the 5 year implied inflation expectation – it was bouncing along near 1.2 percent by late August last year.

In other words, it took considerably greater worries on the deflation front to prod the Fed into action last year.

In my view, Avent’s policy prescription is correct.  For goodness sake, get ahead of this thing.  Does another $200 billion on the balance sheet really matter that much?  But the history of the last few years it this:  They get to the right solution, but it takes some time.  Now, one would think they learned some lessons in the last few years, and would tighten up the timeline.  At the same time, though, one would have thought they learned their lesson from last years ill-timed turn toward hawkishness.  Yet, they once again eagerly walked into that track this year as well.

The slow learning curve on Constitution Ave. argues against action next week.  The reality of the world argued for action last month.  Go figure.

Of course, the slowest learning curves are in Europe.  Via the Wall Street Journal:

The euro zone’s inflation outlook has remained largely unchanged since the European Central Bank‘s July policy meeting, ECB President Jean Claude Trichet said Thursday, noting that he would not rule out further rate increases despite the ECB broadening its efforts to support fragile financial markets.

Speaking in a television interview with Dow Jones Newswires, Trichet said “our judgment is very much the same as in the previous meeting a month ago. We consider that we’re still in a situation where the risks are more on the upside… and that we will have to monitor the situation very closely.”

It speaks for itself.  With policymakers across the Atlantic seemingly oblivious to their own dire situation, the fear gripping financial markets is completely understandable.

Bottom Line:  The market nosedive does not yet guarantee Fed action in the near future.  History has shown the Fed tends to react with a lag.  They should have learned better by now, but if they had learned anything, they would not have pushed forward with hawkish rhetoric earlier this year.  Arguably, they will hold firm, let the markets think they are out of the game and further bid down implied inflation expectations, and then, once the damage is done, up the level of stimulus.  Terrible way to run an economy, I know. Still, it would be remiss to declare anything is certain before the employment report is released.  A downside surprise could promt the Fed into more rapid action.  I am now entirely speechless on the European situation – with Trichet’s ongoing hawkish stance, it has truly devolved into one of those slow-motion train wrecks that one only sees in the movies.

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