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Fed Lowers Funds Rate in Surprise Move, Timing of Further Action Is Not Clear

Tue, Jan 22 2008, 22:30 GMT
by Asha Bangalore

Northern Trust

Fed Lowers Funds Rate in Surprise Move, Timing of Further Action Is Not Clear

In a surprise inter-meeting move, the FOMC lowered the federal funds rate and discount rate 75 bps to 3.50% and 4.00%, respectively.

The statement noted that (1) “weakening economic outlook and increasing downside risks to growth, (2) “deepening of the housing contraction”, and (3) “some softening of labor markets” were reasons for the easing of monetary policy. The statement did not mention equity markets explicitly but cited that “broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households.” After the January 21 drop in global equity prices when the U.S. market was closed, a continued downward trend today in these markets and the sharp drop in U.S equity futures markets this morning before opening probably played a role in today’s Fed action. As of this writing, equity prices in the U.S. appear to be responding in the desired direction by rebounding noticeably from the opening lows.

As the Fed noted, “strains in short-term funding markets have eased somewhat,” with the spread between the 3-month Libor and 3-month Treasury bill rate narrowing to 146 bps from a recent high of 225 bps on December 12, 2007 and 241.5 bps on August 20, 2007. Spreads remain high in the short end but there is an improvement from highs seen in December 2007.

The voting record for today’s cut in the federal funds rate shows that the new rotating schedule for voting Fed Presidents of the FOMC will be in place at the meeting on January 29-30. Among the 2007 voting members of the FOMC, President Poole of the Federal Reserve Bank of St. Louis dissented and he would have preferred to cut at the January 29-30 FOMC meeting. Governor Mishkin was absent and did not vote. Fed President Hoenig, a reputed hawk, voted in favor of a cut in the federal funds rate. Bernanke, Timothy F. Geithner, Charles L. Evans, Donald L. Kohn, Kevin Warsh, Randall S. Kroszner; and Eric S. Rosengren were the other members of the FOMC in favor of lowering the funds rate. The Federal Reserve Banks of Chicago and Minneapolis requested the 75 bps cut in the discount rate.

Further easing of monetary policy is on the table, but the magnitude and timing is less clear. We suspect policy discussions at the January 29-30 will be quite contentious given that President Poole dissented. Two new members of the FOMC – Presidents Fisher and Plosser – are classified as hawks. In addition, a fiscal policy stimulus package is under active consideration. There could be preference to wait until the March 18 FOMC meeting to assess the impact of the monetary and fiscal policy easing put in place. The futures market has priced a 50 bps cut for the January 30 meeting. For today, we maintain a Fed on hold at the January 30 FOMC meeting, with a small possibility of further easing.

The policy statement indicated that the inflation concern was downgraded a few notches. In today’s statement, the FOMC noted that it “expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.” By contrast, the December 11 statement ran as follows: “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.”

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Published on  Tue, Jan 22 2008, 22:33 GMT