It is never easy trying to translate US Federal Reserve policy statements. At least for anyone trying to provide clarity when clarity is exactly what the Fed wants to avoid.

Last week was no different. After Tuesday’s 50 basis point rate cut (the high end of the range forecast by analysts), the Fed defended its position with the following: “The tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.”

It seems… maybe, that the Fed now believes that liquidity is the single greatest risk to continuing growth. This from a group that earlier this year felt that inflation was the major impediment to growth. Which may in the end prove very prophetic.

While the rate cut did wonders for the US financial markets, it did so on the back of an imploding US dollar. In fact for Canadian investors, nearly all of last weeks gains were eliminated by a rising loonie, which ended the week at par with positive momentum.

So is the rate cut good or bad?

Historically, rate cuts have had mixed results when it comes to the financial markets. I noted some comments last week about the last 50 basis point rate cut. It occurred unexpectedly in January 2001.

Stocks surged… initially. Until it became clear to investors just how weak the tech sector was. And more importantly how large an impact that was having on the broader market. In the end the S&P 500 fell more than 10% during 2001. It took another 12 cuts over the next two years before the market finally bottomed.

Having said that, the longer-term record on Fed rate cuts is more promising. According to Business Week, “on average, the S&P 500 was up 3.7% in the three months after an initial cut and 9.5% in six months.”

The answer to the good or bad question then, comes down to whether you believe last week’s rate cut was akin to the move in January 2001, or was it more along the lines of traditional rate cuts, which typically spur economic activity and stock market rallies?

No one can be certain of course. But… when the Fed makes a particularly large move at a time when the market was expecting something less, it suggests a heightened level of concern. Clearly, or maybe not, the Fed stands ready to add liquidity if necessary. Meaning further rate cuts.

The key is how these cuts will impact US economic growth. Which is to say, real growth adjusted for inflation. That’s important to understand, because lower rates theoretically encourage consumer spending, which fuels economic growth. But if in the process, inflation rises faster then nominal growth, real growth actually slows. Not a pretty picture, and one that the Fed has been trying to avoid all along.

When the Fed cut rates and the US dollar declines as a result, the world sees inflationary risk. The US is a major importer, and a weaker US dollar means higher prices for imports which translates into higher consumer prices. In the end, slowing real economic growth. Sometimes referred to as stagflation.

We assume the Fed recognizes the longer term risk. We also assume that the governors believe that the greater short term risk is a slowdown perpetrated by a credit crunch. The theory is that stable prices will do nothing for growth if the consumer is not able to finance major purchases. That’s referred to this as a recession.

The challenge is to find some middle ground. A place where prices remain relatively stable, while consumers have the necessary liquidity. To do that you have to perform the equivalent of a Cirque du Soleil juggling act. Keeping an eye on the US dollar, market momentum (i.e. with a four year old bull market perception is critical), consumer sentiment (i.e. is there a risk I will lose my job), and ease of credit. I’m not sure the Fed is that athletic.

For me, it is difficult to believe in a Goldilocks scenario. Particularly at a time of year (i.e. October and November) when the financial markets have traditionally been vulnerable. I could be wrong… or not, but I would argue that keeping some cash on the sidelines, or buying index puts (i.e. puts on the iShares S&P/TSX 60 index, symbol XIU) may prove beneficial.