The artful dance of liquidity

Not that we needed much confirmation, but the Federal Reserve Board’s actions last week confirmed the seriousness of the financial crisis that was triggered by the bursting of the housing bubble.

The Fed’s three-pronged approach — arranging for the sale of The Bear Stearns Cos. Inc. to JPMorgan Chase & Co., both of New York, at a fire-sale price, accepting triple-A mortgage-backed securities as collateral for its loans and cutting the federal funds rate by 0.75 percentage points — was necessary to prevent the financial system from grinding to a halt.

The key, of course, was liquidity, and its addition in just the right quantity and at the appropriate time.

Through its actions, the Federal Reserve injected more credit into the credit markets and sent a message that it stood prepared to do all in its power to prevent the system from seizing up and devastating the remainder of the economy.

The actions were designed to bolster the confidence of banks and investors, reduce the fear of counterparty defaults, unclog the mortgage market and encourage new lending.

But even if the Fed’s actions do prevent the financial crisis from worsening and dragging the weak economy into a severe recession, its work isn’t done.

At some point, the nation’s central bank must extract that extra liquidity from the system. If it bungles that maneuver — and some critics say it has bungled the injection of liquidity, which has been a case of too little too late, at least until last week — all investors, consumers and businesses are likely to pay a price.

The first risk is that the Fed will slow credit too early and too quickly, causing the economy to slip back into recession, or at least stagnation. The result would be a dormant stock market.

That is what happened in Japan over most of the past two decades. The Japanese central bank and government acted prematurely to withdraw liquidity and stimuli each time the economy seemed to be recovering from the collapses of 1989.

As a result, the Japanese economy has experienced slow growth for almost 20 years, while the Japanese stock market has never approached its 1989 peak, or even half that level.

All should hope that the Fed has studied and learned from the Japanese failures.

On the other hand, there is a risk that the Fed will be too late and too slow in withdrawing the extra liquidity it has provided, triggering significant inflation.

Inflation already is appearing, and the key questions are: how high will it get? And what can investors do to protect themselves?

No one can say how high inflation will go, but if it remains moderate, say 2% to 3%, stocks will offer protection. If inflation rises above 4% a year, however, stocks are likely to provide little inflation protection.

According to a study by Steve Leuthold, founder of The Leuthold Group, an investment research and mutual fund company in Minneapolis, the median annual stock market return when inflation tops 4% is only 2%. When inflation is above 8%, the median return is 2.8%.

The Fed’s work isn’t even half done. It is likely to take additional steps before the crisis is behind us.

But it is a delicate dance.

The Fed must take the right steps at the right time to keep inflation at bay while preventing the economy from slipping into malaise.