Monday, December 10, 2007

Market Watch: FOMC December 07

FOMC to give green light:

The Fed is widely expected to deliver a 25 basis points cut when the FOMC releases its latest monetary policy statement Tuesday evening (19:15 GMT). There seems little doubt a cut is in the offing, with some analysts even predicting an aggressive 50 basis points easing, although the chances of a cut of this magnitude appear to be dwindling. The minutes of the last FOMC meeting that were released on November 20th appeared to rule out a further cut this year as we were told the cut on October 31st was a ‘close call.’ In the past two weeks we have witnessed an about-turn with Fed Chairman Ben Bernanke and his deputy Donald Koln issuing very dovish statements, effectively turning the minutes of the October meeting on their head and signalling to markets the Fed was ready to ease again. Since that October meeting economic data has been at best mixed, but there have been further significant write-downs from banks and financial institutions over the subprime crisis and credit conditions have tightened. Inflation meanwhile has moved steadily upwards with the headline inflation rate reaching 3.5% in October and expected to print over 4% in November when the data is released next Friday.

There is little doubt that if the subprime fiasco was not having such an adverse affect on market credit conditions, the Fed would not be about to cut rates this week. There may well be considerable unease within the FOMC to have to cut rates at all because as we close out 2007, we move into a new period where the year on year inflation rate can easily tick up a notch or two (US core consumer price inflation eased progressively early in 2007 and as we move into 2008, the year over year comparisons may gradually show a marked deterioration in the core inflation rate).

The Fed’s greatest headache is tightening in credit markets and a creative FOMC might choose to customise a solution Tuesday which focuses on the Fed’s discount overnight rate. The discount rate is the rate the bank offers to major lending institutions but is not commonly used at present because of the stigma attached with going to the Fed for borrowings. The FOMC could possibly vote to reduce the discount rate by 0.5% tomorrow, bringing the discount rate down to 4.5%, while at the same time reducing the Fed Funds rate by 0.25% to 4.25%. The logic is that if the discount rate is lowered substantially, more banks will be enticed to come to the Fed’s discount window, rather than paying higher rates through lending from other financial institutions.

Last Friday’s payroll report revealed that while growth continues to slow, the labour market is healthy and unemployment at 4.7% remains at a historically low level. An aggressive 50 basis point cut Tuesday could send all the wrong signals about the US economy and indeed help make a recession a self-fulfilling prophecy. Many FOMC members will feel they have been railroaded into a further cut by Messrs Bernanke and Koln and are most unlikely to vote for anything more than a 0.25% reduction in the Fed Funds rate.

The statement Tuesday needs to be read very closely 1) to see if the policy decision was unanimous and 2) to see if the Fed shifts from the rather neutral stance of the last statement to a more dovish line this time round.

Forecast: 0.25% cut in the Fed funds rate and a 0.50% cut in the discount rate. The dollar will probably fall in the period immediately after the announcement, but should soon rebound, unless the FOMC is seen to have shifted aggressively towards the easing side in its statement, or if the FOMC surprises and chooses to cut the Fed Funds rate by 0.50%.

Ted B - Dec 10

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