Investors were surprised and excited by the cut in the federal funds rate yesterday. The move touched off a 336 point rally in the Dow and significantly changes the landscape in US financial markets. The ease in rates is an attempt to increase liquidity that has dried up in the financial system and will likely encourage banks to begin opening their coffers to both consumers and corporations, and will likely have a soothing effect on the beleaguered commercial paper market.

A view of recent history reveals that overconfidence in low rates during the last few years of the Greenspan era encouraged consumers and businesses alike to take advantage of easy credit in order to finance spending and investments. Banks were able to take advantage of financial derivatives and easy regulations to lend to some of the riskiest borrowers as increasing home and other real asset prices continued to rise giving the collateral significant value appreciation, thus leading lenders to believe their assets were safe with pledged collateral prices providing the stability.

Problems associated with easy monetary policy did not show up immediately as borrowers who got in over their head had these increasing real assets to fall back on, refinance, and thereby stall any adverse consequence. Unbeknown to most US investors, the rise in prices of real assets was very much offset by a falling dollar as the US continued to print money to keep up with the demand for cash fueled by easy economic policy. So while houses and land and even stocks were rising in dollar terms, they were actually dropping for the most part when denominated in other currencies. This has been (and will continue to be) a concern to overseas investors who have financed a great bit of the expansion we have enjoyed since the stock market bottomed in 2002.

This summer as funds found themselves leveraged to the hilt, banks found themselves over committed, and consumers were no longer able to refinance their debt at zero percent or increase the line on their HELOC, the economy and the market began working through the excesses in a painful but healthy process called deleveraging. Many private equity deals that had been announced were not able to be completed. Mortgage companies couldn’t get funding to roll out more loans. Investors who had multiple houses were unable to find buyers when they realized they needed to sell the properties. The process was difficult but necessary similar to an individual who decides to stop spending more than he makes and begins the process of budgeting based on income instead of based on what he wishes to consume.

Yesterday effectively curtailed the deleveraging move and will likely perpetuate the excesses that made such deleveraging necessary. Banks will find it easier to fund private equity deals, mortgages will be more likely to be written, and zero percent interest teaser rates will fill every consumers mailbox by the weekend. At the end of the year, Americans will have more dollars in their pockets (even if they are absent on their personal balance sheets) but the biggest question will now become “what are those dollars worth?”

A deadly side effect of this easing in credit is the looming inflation along with devaluation of the dollar compared to other currencies. The lower US interest rate calls into question the wisdom of China, Japan and any other foreign central bank investing in (essentially funding) the US dollar. A falling dollar may not be a concern to most Americans who get paid and spend in the homeland, but the ramifications reach into every coffer whether noticed or not. Inflation will accompany this rate increase and could devastate many corners of our economy. These corners have names and faces who will likely look back on this day while reading history books with their children and wonder how we got in trouble so deeply.

A devalued dollar makes imports more expensive as the dollar can’t buy the same amount of goods. In an economy that consumes significantly more than it produces (see the trade balance figures) this is a major problem. Many counter this argument by saying that a lower dollar makes our exports cheaper to international buyers. This is true, but most likely, our costs increase so the margins do not get significant benefits from this increase in pricing power. Eve if exports were wildly more attractive and margins remained robust, the fact that we as a country import significantly more than we export, the net effect will be very negative.

As the market moves higher, conservative investors and lenders alike will have to scramble to lay off bearish bets and “get with the program” even if simply to mitigate the risk of being short, or holding non-performing hard assets. The benefits could easily last through the end of the year or into next year as the market prices in easy credit and resurgence in consumer spending. However, the clouds that were pushed back are still looming and are being given time to grow larger as they wait for the eventual rainfall. While the sun is shining on Bernanke today, I fear we are creating a future storm that may test our resolve as Americans.