Tuesday, January 29, 2008

Market Watch: Will the Fed deliver on Jan 30?

Futures markets are pricing in an 80% chance of a 50 basis points cut Wednesday, to follow the 75 basis points cut from last Tuesday, meaning if the Fed cedes to futures market expectations tomorrow, the Fed Funds rate will have declined by a massive 225 basis points, or 2.25%, in just 4 months. If this is the outcome, Bernanke and co. will be cheered by stock market investors and the Fed certainly can’t be accused of watching from behind the curve, although many inflation watchers are certain to accuse the Fed of bowing to Wall Street pressure and abandoning longer-run economic sustainability, in favour of short-run economic growth. What are the arguments for against the various options open to the Fed?

Why Cut the Fed Funds rate by 50 basis points?

a) Markets expect it and were the Fed not to deliver Wednesday it may cause renewed volatility and a sharp downturn in stock prices and subsequently the value of investment portfolios of US households.

b) A credit crunch remains and more is needed from the Fed to free up liquidity and get the banking system working normally. A 50 basis points cut will enable cheaper credit and encourage inter-bank lending to operate more freely.

c) Aggressive policy action, having cut the base lending rate by 1.25% in a week, is certain to stimulate growth activity, which may steer the economy clear of a sharp slowdown or recession.

d) The momentum generated by last week’s emergency cut and the Administration’s stimulus package will only be maintained if followed by this further ‘expected’ move, to help restore consumer confidence.

e) Getting monetary easing out of the way quickly will lead to a significant bounce in the dollar through the remainder of the year, when markets focus elsewhere and price in monetary easing in other economies. A recovery in the dollar will help raise foreign investment and reduce import inflation costs.

f) The housing sector in the US is in recession and the only way to stimulate any form of recovery is to cut the cost of borrowing, aggressively.

g) The Fed does not meet again until March and that will be too long to wait before further policy easing is required.

Why not cut the Fed funds rate by 50 basis points?

a) The Fed has already given more than what was originally expected in January, when the 75 basis points emergency cut was announced last week. Interest rate cuts take a long time to play out in terms of impact on the wider economy and there is no urgency to act again so soon.

b) Being too aggressive in such a short period of time will signal the Fed is panicking and it will undermine confidence rather than the contrary - in essence another aggressive rate cut will help fuel opinion that the economy is already in recession.

c) Inflation is on the rise and there are severe warning signs emanating from the current rally in gold and oil prices. The US is currently experiencing stagflation and aggressive rate cuts from the Fed now are certain to put the US economy into an even deeper period of stagflation, while the economic benefits from those cuts won’t be seen for at least 6-12 months. No Central Bank wants to be accused of being soft on inflation, but that is exactly where the Fed is at.

d) Economic data out of the US has not yet pointed to a recession and even allowing for major problems in the housing sector, the economy has coped reasonably well. Outside of quarter 4 (for which we have not yet seen the data), in 2007 the US economy grew stronger than that of all other major developed nations, including Japan and the euro area.

e) The extent to which the ‘rogue trader’ impacted global stock markets early last week may never be known, but the story will never go away and if this event, even in part, led to the US Federal Reserve cutting interest rates by the most in 25 years on Jan 22, the Fed’s credibility is in tatters. If the Fed keeps rates on hold this week, the committee can at least argue what they did was to bring their decision forward a week, to prevent a major stock market crash. A further cut this week however will add weight to claims that a single stock market irregularity led to 75 basis points indefinitely being shaved off the Fed Funds rate.

f) A decline in the Fed Funds rate to 3.0% will very much restrict the Fed from responding to any worsening crisis in the months to come, when further action may be needed from them. Using all its ammunition now will largely make the Fed redundant going forward, particularly if inflations risks do not disappear.

g) Aggressive Fed easing in the past led to the current fiasco we see with the subprime issue and the credit crunch in financial markets. If the Fed has learned from the past, it won’t repeat the same mistakes again, or will it?

h) The Fed stands accused in some quarters of giving too much preference to Wall Street over Main Street and it is the only Central Bank in the world that directly changed monetary policy to help out investors and stock markets that got into trouble recently. The Fed made a 360 degree turn in its message when it cut rates back in December and last September’s 50 basis points rate cut was a direct response to the then credit crisis which saw a downturn in stock prices. Last week’s 75 basis points cut was the most alarming, given Asian and European Central Banks did nothing, even though it was the stock markets in these jurisdictions which actually experienced the major sell-off. Further easing this week by the Fed will be seen as further evidence of a Central Bank responding to stock market demands.

i) The dollar. While not high on the Fed’s list of concerns to date, further monetary easing will only further erode confidence in the dollar, resulting in more depreciation in the currency and leading to a further rise in the cost of imports, particularly fuel and energy, which will only add to domestic inflation risks.

j) If the Fed wishes to be seen to be seen to be consistent in its commitment to policy easing and that last week’s move was not a once-off knee-jerk reaction, then a cut of 25 basis points should be more than enough on January 30, to keep its credibility intact.

Ted B - Jan 30

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