FOMC walks on eggshells

Has the Fed lost the plot? If one was to judge the reaction on Wall Street, where the major averages plunged by more than 2% each Wednesday, it would seem so. But then perhaps it is greedy investors and those TV pundits that beam from our screens who have essentially lost the plot and maybe the Fed is merely doing its job and trying to keep us all on the straight and narrow? A 50 basis points cut on the Fed Funds rate was never on the cards yesterday and although one Fed member believed it appropriate (Eric Rosengren voted for a 0.5% cut in the Fed Funds rate), the fact any cut was delivered at all demonstrated the Fed had essentially completed a 360 degree about-turn in the past 2 weeks. If the Fed is to be criticised one can point to the lack of creativity in not doing more with the discount rate. A 50 basis point cut in the discount rate would surely have helped ease the tightening which has intensified in recent weeks in credit markets. The fact the Fed came out late last night with a statement indicating it is prepared to do more to ease the liquidity problem is an admission of maybe not having done enough earlier and rather than help, it undermines the Fed’s credibility.

The Fed however could not have done more with the Fed Funds rate and one has to remember the benchmark rate has now fallen 1% in the past 3 months, something few would have envisioned back in September. The Fed’s December statement was more neutral than the October statement, but still places emphasis on inflation ‘Readings on core inflation have improved modestly this year, but elevated energy and commodity prices, among other factors, may put upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.” Many of our less-initiated TV-pundit friends baulked at this sentence, believing the Fed should instead have told the market the door was left open for more aggressive rate cuts and eh…surging stock prices. What these pundits forget, or rather choose to ignore, is that US headline inflation which was running at 3.5% in October is expected to print at over 4% in November when the data is released this Friday. US core inflation is going to rise early next year, possibly sharply, and indeed were the Fed to have followed the example of the ECB, there would not only be no rate cuts, but no prospect of any, while inflation is such a significant threat, even if this may compromise growth prospects. The problem for the Fed is the Committee allows itself to be bullied by financial markets moreover any other major Central Bank and rather than allow Wall Street taste the downside reality of an economic cycle, the Fed rides in and attempts to put off the inevitable. This rather doomed strategy will soon see the Fed run out of basis points and it could mean the Fed pushes the US economy into a sustained period of stagflation, from believe it or not, as early as the first quarter of 2008 (are we to take headline inflation as the measure we might be there already).

So in many senses the Fed could certainly not have gone further on the Fed Funds rate and there is a very strong inflation argument to say they should not have moved at all Tuesday. We have to remember the last print of US growth was the whopping 4.9% recorded in quarter 3. The latest inflation figure will be released this Friday with a strong possibility the headline number will print above 4% while the core number may tick up from 2.2%. Core inflation is going to rise early next year because the year on year comparisons will no longer prove favourable for the measure. Growth is expected to slow to 2.5% in quarter 4 and may even slow further in quarter one of 2008. The Fed is walking on eggshells and there will be a lot of hard thinking for FOMC members between now and the end of January, when the Committee is scheduled to meet again.

Ted B - Dec 12