Former Fed Chairman Paul Volcker gave testimony today before a Joint Economic Committee of Congress. He addressed the current financial and economic environment and the role of the Federal Reserve.

He discussed how the financial market environment has changed considerably since his tenure as Fed Chairman in the early and mid 1980's. He pointed out that financial institutions like investment banks and hedge funds, whose failure can have tremendous effects on the financial system, are lightly regulated. "Systemically important investment-banking institutions should be regulated and supervised" in a similar manner to commercial banks.

Chairman Volcker stressed the need to update the entire regulatory framework, saying "It's not simply a matter of inexperience or technical failures." He also discussed the need to update regulations on a global basis because of the increasing coordination between world central banks.

Federal Reserve Chairman Ben Bernanke addressed the Federal Reserve Bank of Atlanta Financial Markets Conference in Sea Island, Georgia this morning via satellite. He discussed in detail the recent provision of liquidity by the Fed.

He discussed the shift in Fed monetary policy from its primary reliance on open market operations to lending tools used to address the credit crisis more directly. He mentioned the increased use of the Term Auction Facility (TAF) by commercial banks" from $20 billion at the inception of the program to $75 billion in auctions this month" and indicated that the Fed is willing to increase the use of these auctions as necessary.

He also discussed the extension of Fed credit to primary dealers through the Term Securities Lending Facility (TSLF) and the Primary Dealer Credit Facility (PDCF). He mentioned that extending credit to primary dealers was an extraordinary move driven by the potential for a scenario "in which a cascade of failures and liquidations sharply depresses asset prices, with adverse financial and economic implications." He indicated that although improvements in the credit markets have occurred, there are still substantial problems that remain.

Many people are saying that the rise in oil prices is the result of loose monetary policy. They say that there is an easy solution to the problem. Raise interest rates substantially, and the problem will be solved. Since the rise in oil is also the primary cause of rising inflation, the inflation problem will be resolved as well.

There are several problems with this line of reasoning. Oil continued to rise as the Fed began to increase interest rates in 2004. Prices doubled as the Fed substantially tightened monetary policy. Europe also has the some of the same inflation issues that we face despite the refusal of the European Central Bank (ECB) to lower rates.

Then, there are the big questions. Why are oil prices rising? What is the short-term solution?

I believe that the main reason for the rise in oil prices is the rise of the developing world. The two nine hundred pound gorillas in this equation are India and China. Automobile demand is increasing in these countries and is likely to continue in the near future.

This is similar to the rise in oil prices in the late 1960's and early 1970's. After World War II, the United States was the primary industrial power. As the world industrialized, demand for oil increased. The United States was not the only nation driving cars extensively. Supply constraints were also introduced in the mid to late 1970's with the Arab oil embargo and the Iranian revolution.

The Federal Open Market Committee (FOMC) reduced interest rates by a quarter of a percentage point, taking the target Federal Funds Rate to 2% and the Discount Rate to 2.25%, as expected. However, the indication of at least a pause in interest rate cuts was not present. On the contrary, the Fed maintained its dire view of the economy mentioned in the March statement. The only positive indication that it gave was dropping the sentence "However, downside risks to growth remains." Two FOMC members voted against the rate cut as they did previously during the March meeting.

The stock market, which had been up by as much as 1% prior to the Fed announcement gave back all the gains and closed slightly down. Gold closed up slightly, and the dollar closed down.

What were the reasons that the Fed maintained this position and did not indicate a pause?

First, the Fed still believes that there is still substantial risk in the economy and further rate cuts could be necessary. There have been several positive economic and earnings reports lately and the stock market has drifted higher. If the Fed had signaled a pause, it may have been concerned that this could indicate an all-clear signal and ignite a rally. Negative news in the future and additional rate cuts might then be interpreted negatively. This could trigger a steeper falloff, increasing volatility. The Fed decided to take a cautious approach and manage investor expectations.

The Federal Open Market Committee (FOMC) will announce its decision on interest rates on Wednesday at the end of a two-day meeting -- one that will be watched more closely than ever before. The financial markets have experienced incredible volatility over the last several months, almost disintegrating on several occasions. However, the Fed's string of interest rate cuts has managed to stabilize the situation, at least temporarily. Whether the market remains stable depends in good part on the Fed's next actions.

There is a general consensus, which I agree with, that the FOMC will cut both the short-term rates it controls -- the Fed Funds Rate and the Discount Rate -- by 0.25% and then indicate that it will pause in taking any further action at its next meeting. Given this consensus, the supporting statements the Fed issues will be what are truly important to investors. The devil, in this case, really is in the details.

In the past, the Bernanke Fed had a serious perception problem. Many investors thought that it was behind the curve, unable to stop a meltdown of the financial markets and a severe recession. The recent rate cuts and injection of liquidity through various lending facilities, along with facilitating the Bear Stearns sale, have eased the situation. Bernanke must be careful not to damage this newly found credibility in the upcoming FOMC statement.

With economic reports and earnings numbers being released this week, we have been on a financial roller coaster. With regard to earnings numbers, we had General Electric disappoint, but IBM beat expectations and gave positive guidance for the future. Inflation numbers are high, but core inflation seems to be under control. The economy continues to deteriorate but does not seem to be falling off the cliff. How does an investor interpret all this? Is the glass half-full or half-empty?

The economy is clearly experiencing pain from the credit crisis. Even if we are not in a recession, it sure feels like one to the average person. Pessimism is the watchword of the day.

However, the big question is how much of this is already discounted by the equity market? I believe that the answer is that much of this is already built into market expectations. Unless we have another run on a major financial institution, the economy goes into freefall, or major oil supply disruption occurs, the market is already discounting most of the negative information.

In addition, we are approaching the November election. With a Republican in the White House and Democrats in control of Congress, no one wants to be blamed for a bad market or economy. The Fed is injecting a massive amount of liquidity into the system, and the tax rebates should be arriving shortly.

Does this mean a rally will arrive soon? It is a possibility. However, remember that the credit problems still remain. Any solutions will only be addressed after the election. The key variable is the rise in oil prices which is driving inflation. In the short term, it acts as a tax on the consumer and limits the Fed's options. As long as oil prices continue to rise, any rallies are likely to be muted and short-term in nature.

Doug Roberts is the Founder and Chief Investment Strategist for ChannelCapitalResearch.com and the author of Follow the Fed to Investment Success: The Effortless Strategy for Beating Wall Street. He previously held executive positions at Morgan Stanley Group and Sanford C. Bernstein & Co.

Recently, former Federal Reserve Chairman Alan Greenspan announced that the country is currently in a recession and that "the U.S. economy will not stabilize until the housing markets recover." He compared this to the Savings and Loan crisis of the late 1980s and mentioned that another organization similar to the Resolution Trust Corporation (RTC) may be necessary to resolve the situation.

I have repeatedly highlighted the parallels between the late 1980s and our current crisis. Part of the solution may clearly involve an organization similar to the RTC. This has generated debate over the role of government in resolving the crisis and who should ultimately bear the cost. Nevertheless, based upon comparing this to the S&L crisis of the late 1980s, there is decent evidence that this crisis will not be resolved until the housing crisis abates.

We may want to examine the differing ways that the Japanese Banking Crisis and the Swedish Banking Insolvency of the 1990s were resolved for guidelines. Under the Japanese scenario, the banks were given a lifeline and hesitated to write down the bad loans. This resulted in one of the longest economic slumps and bear markets in recent history. Only now is Japan starting to emerge from this downturn, almost 20 years after it began.

Federal Reserve Chairman Ben Bernanke testified before Congress today on the economy, the credit crisis and the Fed's involvement in the sale of Bear Stearns to J.P. Morgan Chase. While much of the testimony summarized the Fed's recent actions and positions, there were several high points in the testimony.

First, the Fed Chairman discussed the possibility that the U.S. economy may contract in the first half of 2008. The market temporarily reacted negatively to this announcement and then rebounded. This was probably due to the realization that this also means that the Fed will continue to maintain a loose monetary and credit policy for the near future.

The Fed also showed how close to a global financial meltdown we came. The testimony detailed the reasoning behind the Fed's action to prevent the bankruptcy of Bear Stearns and facilitate its sale. It made clear that because of the interconnectivity of the world financial community, a bankruptcy could have resulted in a meltdown on a global basis, not merely one in U.S. markets.

The plan proposed by Secretary of the Treasury Henry Paulson to revise the United States' financial system is meant as an initial step in reforming the current regulatory environment and institutions. This would be the largest overhaul of the system since the legislation implemented by the Roosevelt administration during the Great Depression. It is needed to deal with current challenges posed by the recent credit crisis.

This is only a first step in the process. Many government agencies will be merged to create even more powerful agencies. However, the key element that stands out in Secretary Paulson's proposal is the new role of the Federal Reserve as a regulatory "Supercop." In essence, the proposal makes the Fed formally responsible for the risk management of our financial system. This would be the third mandate for the Federal Reserve after price stability and full employment.

In several ways, the Fed has already undertaken this role of guaranteeing financial market stability with its assistance in the sale of Bear Stearns (NYSE: BSC) to J.P. Morgan Chase (NYSE: JPM) and the extension of discount window lending to the investment banks acting as primary dealers. This would merely grant the Fed the regulatory authority necessary to do this on a formal basis.

Bear Stearns (NYSE:BSC)was sold to J.P. Morgan Chase (NYSE:JPM)over the weekend for $2 per share in stock. The Federal Reserve also provided substantial financing to J.P. Morgan Chase to facilitate the transaction. This is quite incredible since Bear Stearns stock traded over $60 per share last week and over $100 per share late last year.

The Federal Reserve also announced additional measures to provide liquidity to the market. It lowered the discount rate by 0.25% to 3.25%, reducing the discount window penalty to 0.25% from 0.50%. It also established a lending facility for primary dealers directly as opposed to through banks.

What do we make of all this? The Fed has established that it will not allow the system to fail. It understands the risk that a bankruptcy from a major bank or brokerage firm would cause and will not allow this to occur. This could cause a breakdown of the financial system on a global scale. A similar credit crisis occurred after the Crash of 1987.

On the other hand, this seems to indicate that shareholders will not receive a bailout. The Fed is essentially saying to a non-bank player, such as Bear Stearns, if you get into trouble which endangers the financial system, we will arrange for an orderly pre-packaged bankruptcy. Our concern is the financial system, not your survival. In essence, if you come to us, we are concerned that death occurs in an orderly manner.

This is very similar to the Fed takeover of Continental Illinois in the mid 1980's. This bank was considered too large to fail. The Fed took over, and shareholder value was eliminated.

Any actual bailout will probably be limited to banks that are regulated by the Fed. However, there will be no free lunch. The Fed is concerned with market stabilization now. In the future since these institutions are under the regulation of the Fed, the costs of this bailout will then be accessed on them. If you want to look at precedent for such a situation, the early Chrysler bailout is a good example.

The Fed has indicated that it will not allow the system to fail. However, the penalty for those who put the system in danger will be severe, quite possibly fatal.

Doug Roberts is the Founder and Chief Investment Strategist for ChannelCapitalResearch.com, an independent research firm focusing on investment strategies using the Federal Reserve's impact on the stock prices. He previously held executive positions at Morgan Stanley Group and Sanford C. Bernstein & Co.

The Federal Reserve announced this morning several measures to deal with the current liquidity crisis on Wall Street. It is creating a new Term Securities Lending Facility (TSFL) that will lend Treasury securities for 28 days as opposed to overnight under the current program. The key element of this program is that it will accept residential mortgage-backed securities (MBS) as collateral.

The Fed is also taking coordinated action with the other major central banks: The Bank of Canada, the Bank of England, the European Central Bank and the Swiss National Bank. It has also authorized increases in the currency swap lines with the European Central Bank and the Swiss National Bank.

These actions are significant for several reasons:

• The Fed, by accepting MBS as collateral, is now attempting to inject liquidity directly to the area that is the source of the credit crunch.
• It is extending the term in order to give additional confidence that funding will be available for a longer period of time. No one will lend unless they are certain that funding will be available. This addresses the issue.
• The Fed is taking action on a global basis with other central banks. This an additional measure to build confidence in the financial markets.

Fed Chairman Ben Bernanke appeared before the House today and will appear in the Senate tomorrow. He spoke of the deteriorating economic conditions in the United States in terms of slowing GDP growth and increasing unemployment. The increase in inflation from rising oil and food prices was also discussed.

However, Dr. Bernanke also clearly indicated that the slowing economy was the more immediate concern and that these inflationary pressures would not prevent the Fed from lowering interest rates further to deal with the situation. He mentioned that he believed inflation would moderate as the economy slowed.

Part of the problem with recent cuts in the Fed Funds Rate has been the mixed messages that have accompanied them. Several Fed officials have spoken with both hawkish statements about inflation and dovish comments about the slowing domestic economy. This has led to confusion about the Fed's intent and limited the effectiveness of the cuts.

Dr. Bernanke's testimony, along with Vice Chairman Donald Kohn's speech yesterday, has sent a consistent and clear message that higher inflation will not stop the Fed from lowering rates further. This should give the markets comfort that the Fed will continue to inject liquidity in order to cushion the slowdown.

However, the rate cuts will take time to work its way into the system. Since most of the easing has been recent, we will not be able to judge its effectiveness. In the meantime, market volatility will continue.

Doug Roberts is the Founder and Chief Investment Strategist for ChannelCapitalResearch.com, an independent research firm focusing on investment strategies using the Federal Reserve's impact on the stock prices. He previously held executive positions at Morgan Stanley Group and Sanford C. Bernstein & Co.

Fed Chairman Ben Bernanke along with SEC Chairman Christopher Cox and Treasury Secretary Henry Paulson testified before the Senate Banking Committee on the state of the U.S. economy and financial markets. In his prepared remarks, he focused on the credit crisis in the financial markets, the deteriorating financial conditions of many of the major banks, the housing downturn and the increase in unemployment.

Chairman Bernanke acknowledged the possibility that the economy could slip into a recession but did not say it would do so. He emphasized the moves that the Fed has made to address these problems: the use of the new term auction facility (TAF) and the reduction of the Federal Funds Rate target by 225 basis points from 5 ¼% to 3% since September.

One of the most important aspects of the testimony is the secondary focus on inflation. Chairman Bernanke did not even mention inflation until almost halfway through his testimony. When he did, he clearly relegated it to a secondary role.

He emphasized that his primary focus is on the weak economy. In essence, the Chairman said that he gets it and understands the gravity of the situation. He mentioned the FOMC "will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks."

This is quite a change from his prior statements and further indicates his willingness to take aggressive action to cushion the economic downturn as demonstrated by his two most recent rate cuts. All eyes will be on the next FOMC rate decision for additional confirmation of the Fed's aggressive loosening of monetary policy.

Doug Roberts is the Founder and Chief Investment Strategist for FollowtheFed.com. He previously held executive positions at Morgan Stanley Group and Sanford C. Bernstein & Co.

The stock market finished strongly today. Some of it was attributed to positive news about the municipal bond insurers. However, I believe much of it was due to the belief that the Fed will continue cutting rates as necessary to cushion the slowdown or a potential recession.

Prior to the recent FOMC statement and the inter-meeting rate cut, the Fed was sending out mixed signals regarding rate cuts. It tried to establish its credentials as an inflation hawk; however, it also left uncertainty about its ability to deal with a recession. This reduced the effectiveness of the initial rate cuts. Many believe that the Fed would be caught behind the curve in dealing with a potential recession.

The combined decrease in the Federal Funds Rate of 1.25% in the last two weeks along with the accompanying FOMC statement has established the Bernanke Fed's credentials for dealing with a potential recession. It has replaced the current market confusion with confidence in the Fed.

The Federal Open Markets Committee (FOMC) made an intra-meeting announcement cutting the Federal Funds Rate Target 75 basis points to 3 ½% and a similar cut in the Discount Rate to 4%. The FOMC justified the move because "broader financial markets have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets."

In a separate move, the Canadian Central Bank also announced a rate cut as well.

This emergency move was made ahead of a FOMC meeting next week and after global markets around the world tumbled during the Martin Luther King Day holiday when U.S. markets were closed.

I believe that this move was made to re-establish the idea of the Fed as the lender of last result: the Bernanke Put. Initially, the Fed was reluctant to cut rates for several reasons:

• It was viewed as bailing out the stock market, not the economy;
• There were inflationary pressures from rising all prices;
• U.S. exports largely resulting from a falling dollar seem to be cushioning any drop in the economy.