The Federal Reserve cut the federal funds rate from 5.25% to 4.75% in September and the stock market reacted with an instant gain of 335 points.

The Fed, to much applause, also dropped the discount rate from 5.75% to 5.25%.

Given such cheers on Wall Street it must be that the Fed is taking the correct steps to protect the American economy from the growing mortgage meltdown. Right?

The federal funds rate reduction was bigger than many analysts had expected. That's impressive in some sense and there's no doubt in the short run that the Fed action will help certain borrowers such as those with home equity loans based on the prime rate.

Unfortunately, ARM borrowers with loans about to re-set to new and higher rates, the folks we're allegedly trying to help, won't see relief. The Fed action directly impacts short-term rates, not long-term interest levels. The Fed has little if any real impact on the LIBOR rate, a rate set in Europe and an index widely used to set ARM rates in the U.S.

The Fed reduction sounds pretty much like George Santayana's definition of fanaticism -- that's when you redouble your effort and forget your purpose.

And what is the Fed's core purpose? When last we left off with the Fed its big concern was warding off inflation. If you think we have foreclosure problems now, you'll look at this period as the "good old days" should serious levels of inflation take hold.

With inflation you need more dollars to buy goods. The price of a loaf of bread "goes up" even though the size of the loaf remains the same. A little inflation is generally seen by economists as acceptable, however when inflation levels rise then costs increase.

The Fed, for its part, had a four-year policy of raising the federal funds rate in an effort to hold down spending and thus limit inflation. For instance, it raised the federal funds rate from 1.0 percent in July 2003 to 5.25 percent in July 2006 and kept the federal funds rate at that level until September.

"Readings on core inflation have improved modestly in recent months," said the Federal Reserve's Open Market Committee in August. "However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.

"Although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the outlook for both inflation and economic growth, as implied by incoming information."

What changed so much between August and September that the Fed lowered the discount rate and then lowered the federal funds rate? With lower interest levels there can be more spending, more spending leads to more economic activity and potentially higher levels of inflation. Isn't that what the Fed has been trying to prevent?

Has anyone noticed that despite the Fed's action the value of the dollar in relation to many currencies continues to fall? That the cost of oil is soaring or that the balance-of-payments is still massively unbalanced? Or that the federal government spends far more than it has? Such things all contribute to inflationary pressures.

If inflation levels start to rise then the mortgage rates we have today will also rise, meaning that millions of homeowners will be faced with vastly-higher monthly payments. For those with fixed-rate loans the rising rates will not be an affordability problem -- such loans are a hedge against inflation. But for households with adjustable-rate financing, inflation is a devil at the doorstep, an evil which cannot be ignored.

If the Fed is wrong and inflation begins to emerge, then even minimal rate increases, say to 7 percent or 8 percent, rates which are relatively low by historic standards, will broadly impact millions of homeowners. For those now at the cusp of affordability, higher rates can swamp household budgets.

If inflation is really the core problem we face it will show up in the form of higher interest levels and steeper foreclosure rates by late Spring and early Summer next year. Payment re-sets from toxic loans will surely be a major cause of foreclosures, but the simple mechanism of higher rates will impact the majority of ARM borrowers, not just those troubled by "nontraditional" loans. Suddenly now-comfy and secure ARM borrowers will understand what the "marketplace risk" of adjustable rates really means.

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