FOMC cycles usually have some sort of underlying consistency to them. In this cycle, the underlying consistency has been:

• Unorthodox measures, attempting to use the asset side of the Fed’s balance sheet to solve lending problems among banks and broker-dealers.
• They have effectively “sterilized” their unorthodox measures by withdrawing other liquidity from the system, leading to…
• Lack of growth of the monetary base, which has only risen 2% in the last year, and the last permanent injection of liquidity was 5/7/07. (After reviewing the Annual Reports of the Open Markets desk of the NY Fed 1996-2007, I think that’s a record… it is certainly a record for a loosening cycle. How can you have a loosening cycle without growing the monetary base significantly? Unless they are planning on reversing their policy easing rapidly once the financial crisis is past.)
• They have never cut rates less than expected.

So, that leaves me at a 1% cut in Fed funds tomorrow, with a parallel cut in the now-meaningful discount rate. Now that primary dealers can borrow there, that will be an active window. That said, the Fed will probably try to sterilize any borrowings there, withdrawing liquidity elsewhere.

Come to think of it, that was one of the problems with the Bank of Japan as they slid into their crisis in the 1990s. They always sterilized their monetary policy so that it had little effect, thus restraining inflation, but not doing much for their overleverage situation.

In this case, that’s a mistake. We can live with price inflation. Dealing with the collapse of leverage is a lot tougher. The Fed can use unorthodox measures until their supply of lendable/saleable Treasuries runs out. Then they will have no choice but to begin monetizing the debts of the US Government or its agencies, if they want to attempt further stimulus. Then we will get price inflation. As for me, I would own TIPS here. CPI inflation will likely rise if the bailouts needed exceed the size of the Fed’s balance sheet. I also like agency residential mortgage bonds here. Implied volatilities can’t get that much higher, so we should get some sort of rally.

Let see what happens tomorrow.

Update

So what happens after I hit the publish button, but I receive a great article from Calculated Risk talking about the same issues.