A cloudier economic outlook for the United States Central bank actions and statements continues to be the predominant influence on market direction and investment sentiment. The policymakers have difficult choices to make, but as many analysts have pointed out, the central banks have had a hand in creating current problems through their past actions, namely by providing too much liquidity, for too long, to the system.

In reference to the United States, some observers have said that it would be preferable to have a recession now, rather than seek a so-called "soft landing". This would allow a correction of excesses and imbalances and a more thoroughgoing re-pricing of assets. Of course, there would also be short-term pain, but the longer-term benefits would be in the form of stable non-inflationary growth.

The alternative to a recession would be a drawn-out period of adjustment in which the previous misallocation of resources and the mistakes resulting from zealous risk-taking are not fully removed from the system. In other words, the normal workings of the market system to deal with excesses and imbalances are prevented from being acted out. This would prepare the ground for possible future bubbles and instability.

Of course, one of the goals of a central bank is to mitigate the effects of a normal business cycle. But in the United States, policymakers have rightly been accused of having misused their policy instruments by implementing stimulative measures far too long, leading to excessive risk-taking. This sort of policymaking promotes instability, not stability. In recent statements, Alan Greenspan, the former chairman of the Fed, appears to have conceded that there is some truth to these contentions.

By their recent action, the Fed has signalled that it is very much their intention to avoid a recession. The fifty basis-point cut in the funds rate was not universally expected. So it came as something of a surprise to the markets, which may have been part of the Fed's calculations. As the lowering of the target rate was accompanied by an equivalent cut in the discount rate, this constituted an aggressive move indeed.

The markets interpreted the cuts, along with the accompanying statement, as underlining the priority to fight recession and expressing little concern about inflation or the fate of the dollar. Just to recap what happened to major asset classes after the announcement: stocks surged, long-bond yields rose, commodities and gold spiked higher and the dollar index fell. In other words, the markets were interpreting the injection of liquidity as a measure that would avoid recession but hurt inflation.

Despite the rhetoric coming from Fed notables,

the implementation of easier monetary conditions does constitute a bailout of speculators. Apart from professionals in the financial markets, there are also the multitudes of homeowners who have been speculating on ever rising house prices. And, until recently, this was financed by cheap loans. But the speculative game has turned nasty. When house prices fall and financing becomes more difficult and expensive, it is going to hurt - as it should do. Real house prices in the United States have risen tremendously in recent years and are at historic highs, even when we take account of recent corrections. They are going to fall further.

There is a myth that the bad boys have been punished by the credit crunch and the sub-prime debacle, and have learnt their lesson. That's not true. It is the fools that have been punished. The bad boys made a lot of money during the liquidity-induced boom. They have banked their gains and will take advantage of any opportunity the Fed offers as it pumps more liquidity into the economy As we said previously, when there is a hazard of economic slowdown, the Fed isn't going to be overly concerned with the problem of moral hazard. Wall Street types welcomed the Bernanke "put" with a round of cheering, pushing stocks higher. The expectations are that Ben will deliver many more interest-rate cuts to goose up the economy.

However, the housing market shows few signs of stabilising, let alone making a turnaround. House prices continue to fall though, of course, there are regional variations. Naturally, many of those areas which had experienced the sharpest price increases are also suffering the biggest declines.

Home construction is down, and builders are desperately trying to move unsold inventory. Foreclosures will rise and dump even more supply on the market. Meanwhile, mortgages are tougher to get and more expensive. The Fed's aggressive actions are stoking inflation fears, leading to a rise in longer-term interest rates.

Last week's data release on new home sales showed a larger-than-expected decline. A reasonable forecast may have been that this would trouble the stock market. In fact, the market interpreted the news positively and moved higher. The thinking is that bad housing trends will ensure further housing trends will ensure further substantial rate cuts by the Fed.

The basic premise by the equity market is that easy monetary policy will result in a relatively mild growth slowdown and the economy will pick up by the middle of next year. However, two other scenarios are possible. (1): that the economy will fall into recession, despite all the efforts made by the Fed. (2): that recession will be avoided, but there will be an extended period of weak growth.

A weakening economy will weigh on corporate earnings growth. We will get some indication of the trend when companies issue forward outlooks in the upcoming earnings reporting season. As for analysts' consensus estimates, if history is a guide, they tend to underestimate the decline in earnings growth when it is falling and its acceleration when it is on the increase.

It was clear, when Bernanke took over the helm at the Fed that he was facing a far more challenging environment than what the departing Alan Greenspan had to handle. The former chairman of the Federal Reserve was lucky. But he was knowledgeable and smart enough to know that he could take big risks, because the environmental conditions were favourable, and mistakes would not result in nasty repercussions under his watch.

Unfortunately, Bernanke has to act under much tighter constraints, and mistakes are far more likely to bring about punishment. Bernanke is under tremendous political pressure to pump more liquidity into the system and bail out homeowners. As a consequence, the Fed's inflation-fighting credentials are under threat. We have argued previously that the economy's productivity growth rate will be lower than it has been in the past. This has implications for monetary policy, inflation, household consumption, corporate profitability and the dollar.

The household sector has yet to realise that in a lower-productivity-growth environment, its net-worth growth will also be slower. Unless there is additional vendor financing of US consumption growth by foreigners, the household sector has to curb spending growth and raise the savings rate.

Inflation risks are on the rise. Commodity prices have been increasing fairly strongly across a broad range of sub-components. Agricultural commodities have been the focus of attention because of supply/demand imbalances. Some of the shortages may only be cyclical ones. But if there is a structural story as well, then that may bias inflationary risk to the upside over time. As for oil, crude prices remain high and will be feeding through to end products. Prices at the pump have yet to move higher.

China's measured inflation rate is driven by higher food prices; and pork in particular. If food prices remain high for an extended period, they will eventually affect costs. Higher commodity prices, in general, are also feeding through into the cost of production.

Meanwhile, the renminbi is rising slowly but steadily, even as the Americans and Europeans are pressuring China for a faster pace of appreciation. Under these conditions, China's role as a deflationary force in the global economy may be coming to an end. Over in the US, dollar weakness adds to inflation risks.

In addition to the United States, central bank credibility is also on the line in Europe and the UK. The politician's are getting into the act of pressuring the central banks to ease monetary conditions. This raises the question of the banks' immunity from political interference. The organisational arrangements are for the European Central Bank and the Bank of England to have a large measure of independence. But the threat to change the arrangements is always present.

Nicolas Sarkozy, the French president, has continued to call for the ECB to follow the Fed's example. To counter this, Angela Merkel, the German chancellor, has strongly defended the independence of the ECB. Now, the Eurozone's central bank was modelled after the Bundesbank which had a large measure of independence.

The Bundesbank had integrity and credibility and was immune from interference. It was widely respected, and nobody feared that it would debauch the currency. Over in England, Mervyn King, the governor of the Bank of England has been treated disgracefully by the politicians for his correct stance on moral hazard. He is under pressure to open the liquidity tap.

Stock markets have rallied since the Fed eased, and some have raced ahead faster than others. Asian markets have risen strongly - other than Japan, of course. Emerging markets have surpassed their pre-correction peak in June. BRICs (Brazil, Russia, India, and China) are particularly in favour.

As for the US stock market, mega-caps are being embraced enthusiastically.From the beginning of the year until the end of June, the Russell 2000 (small caps) beat the Russell Top 50 (meg-caps).

But from then until the end of September mega-caps have thrashed the small fry. The preference for large companies makes sense.They have the greatest degree of international exposure and stand to benefit from dollar weakness.In addition, they are best placed, financially, to weather an economic downturn.

Iraj Pouyandeh is a Strategist and Senior Portfolio Manager at LOM Asset Management. He manages the LOM Global Equity Fund. For more information on LOM Asset Management please visit www.lomam.com