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Friday Notes

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Fed: The first cut was the deepest

Fri, Oct 26 2007, 15:38 GMT
by HVB Group Global Markets Research

HVB Group

• Fed. The FOMC will lower its target rate again next Wednesday. This time, however, we expect "only" a 25 bp cut to 4.50%. A renewed 50 bp rate cut could unsettle investors by implying that financial market conditions and the economy are in more precarious shape than the Fed has been depicting in its public statements so far (pages 2-4).
• Risk. With a housing market still in free fall (cf. chart), however, the risk of additional rate cuts thereafter has increased. The Fed would have to act if, above all, the slowdown in private consumption proved to be much stronger than projected so far (main risk scenario).
• Consumption. Persistently solid income growth should, however, prevent a real slump in consumption expenditures. Nevertheless, negative wealth effects combined with rising debt service are increasingly crimping growth of US household expenditures (pages 5-8).
• Global interest rate cycle. Even the central banks with a clear tightening bias so far are now acting more cautiously by adopting a wait & see attitude. Like the ECB, the Swiss National Bank is no longer expected to tighten before mid-2008, and the Norges Bank will postpone its three projected rate hikes (pages 9-10 & 11-12).

• Further topics:

• Data outlook: EMU inflation clearly above 2%, labor markets to stay robust; US: strong Q3 GDP growth & lower non-farm payrolls (p. 13).
• Market outlook: Bond markets to remain volatile; USD to continue to weaken (page 22).

FOMC likely to cut key rate by 25 basis points next week

• The Federal Reserve’s policy setting group, the Federal Open Market Committee or FOMC, will decide to cut the federal funds target rate by an additional 25 basis points to 4.50% when it meets on October 31.
• The rationale will echo last month’s: the overall economy is threatened by a developing credit squeeze that originated in the subprime mortgage sector, but has become a problem for credit markets in general.
• Strong voices within the Fed will push for another 50 basis point cut, on the grounds that it would be more effective.
• The majority, however, will likely give weight to concerns about the possible inflationary consequences of commodity price increases and depreciation of the dollar in the foreign exchange markets and thus temporize with only a 25 basis point rate cut next Wednesday.
• The risk that the Fed may judge the downside risks to growth are worse than it had previously estimated, and will thus lean toward even greater accommodation in the months ahead, has increased recently.

Background: financial market disorder exposes serious risks to growth

In the relatively brief time-span of about eight weeks, the Federal Reserve dumped its long-standing anti-inflation bias and abruptly switched to a policy of averting a substantial slowdown in the US economy. Interestingly, a noticeable deceleration of growth in the twelve months from April 2006 through March 2007 – recall that real GDP barely rose at all in Q1 2007, after a string of sub-par results in the final three quarters of 2006 – did not prod the Fed to contemplate even a balanced risk assessment. Inflation control took priority. What did force a reassessment of the relative risks were the credit market dislocations that developed in mid-July and reached crisis levels during August. The Fed responded with a series of actions to relieve a major liquidity squeeze in the interbank market. And even as economic growth picked up smartly in Q2 and Q3 2007, the FOMC followed up with an unexpectedly forceful 50 basis point cut in the federal funds rate target at its September 18 meeting. The minutes of the September FOMC meeting explained, “the incoming data in many cases were of limited value in assessing the likely evolution of economic activity and prices, on which the Committee's policy decision must be based.” In short, no matter how satisfactory the current economic figures may be, the Fed is basing policy these days on its real GDP growth forecasts for 2008. And those have been revised down from the 2.5-3.0% range that Chairman Bernanke disclosed to Congress back in July.

The reason for a gloomier forecast is straightforward: the financial market turmoil carries the risk of a decline in credit availability and correspondingly lower consumer and business spending. The minutes put it succinctly: “Members judged that a lowering of the target funds rate was appropriate to help offset the effects of tighter financial conditions on the economic outlook. Without such policy action, members saw a risk that tightening credit conditions and an intensifying housing correction would lead to significant broader weakness in output and employment. Similarly, the impaired functioning of financial markets might persist for some time or possibly worsen, with negative implications for economic activity.” The issue for next week’s FOMC meeting is simple: Is this judgment still valid?

Three options: 0, 25 bp or 50 bp

Fed officials will likely consider three options at the October 31 FOMC meeting: holding the federal funds rate steady, cutting it further by 25 basis points, or cutting it another 50 basis points. Here are the main arguments for each of these choices:

No change: The argument in favor of leaving the Fed funds rate at 4.75% is as follows: The Fed took extraordinary action to prevent a future slide in consumer and business spending when it lowered the key rate by 50 basis points. One justification was that the labor market had suddenly weakened and non-farm payrolls had fallen during the summer. But subsequent data revisions showed that employment actually had continued to increase moderately, and initial unemployment claims were little changed from the levels that prevailed before the financial market disturbance. Moreover, consumption expenditures moved ahead strongly, keeping real GDP growth above potential for both Q2 and Q3 2007 (cf. Research Note by Harm Bandholz & chart).

And the stock market rallied to near-record levels, offsetting much of the drag on household wealth from declines in housing prices. Meanwhile, the Fed’s aggressive action triggered higher commodity prices and a further decline in the value of the dollar, both of which can increase the inflation dangers. A pause in easing to determine whether the financial dislocations really do have an adverse effect on the economy at large makes sense if the Fed is worried about preserving its credibility on inflation.

25 basis-point cut in the Fed funds target rate: The housing market continues to struggle, as demonstrated by the plunge in housing starts and new building permits in September. Sales and prices of existing homes also sank (cf. chart). Inventories of unsold houses remain at levels that are bound to exert downward pressure on home prices. Faced with increasing delinquencies on subprime mortgages and signs that other mortgages previously thought to be of low risk were also getting into trouble, losses continue to mount. Thus financial institutions have started tightening lending standards. Moreover, while progress has been made toward restoring normal functioning of money markets, the situation is fragile.

Admittedly, so far consumers have not reacted much to the housing slump. But it is highly likely that before long they will begin to scale back purchases, especially of autos and household durable goods. Under these circumstances, a further cut in the federal funds rate is justified in order to offset the tightening in credit conditions and to encourage further normalization of financial market activity. But the potential inflationary consequences of higher oil and other commodity prices, plus the further depreciation of the dollar in foreign exchange markets, argues for a more moderate policy response than last month.

50 basis-point Fed funds rate cut: The case for an additional 50 basis point cut is similar to last month’s FOMC policy statement. It is prospective, rather than current, economic conditions that are at risk from a further weakening in the housing market and an emerging credit crunch. Already, there are signs that the positive effects of September’s FOMC decision are wearing off, amid evidence that the financial condition of a number of important institutions remains severely strained. Thus, front-loading monetary accommodation will do the most to lessen the danger that economic prospects will be seriously impaired. In general, the beneficial effects of a monetary policy initiative are optimized when a central bank takes actions over and above what the financial markets expect. That was given an almost textbook demonstration in September, when the Fed surprised almost everybody with a 50 basis point reduction in the key rate target, rather than the 25 basis point cut most were expecting. Similar expectations have jelled for next week, so a biggerthan- expected benchmark rate reduction will do the most good. As for understandable concerns about the inflationary consequences of higher commodity prices and a lower dollar, those adverse effects are likely to be small in a period of decelerating growth.

Fed to choose middle course

Our judgment is that the FOMC will agonize over the latter two options but in the end will decide to temporize with a 25 basis point cut (cf. chart).

The clinching argument will probably be that the central bank retains all the flexibility it needs to take further measures should a faster and more widespread weakening in the economy ensue. Otherwise, waiting to see how business conditions unfold over the coming weeks is a prudent course, in view of the sensitivity of markets to an outright abandonment of concern about inflation. At the same time, a 50 basis-point cut would suggest that financial market conditions and the broader economy are in more precarious shape than the Fed has been depicting in its public statements. Thus, such an action could have a perverse impact by eroding sentiment, rather than reinforcing confidence. Naturally, whether the Fed cuts the federal funds rate even further will depend on how the economic data develop. But the markets will take for granted that policy will remain tilted to supporting growth, rather than combating inflation, for some time to come.

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Published on  Fri, Oct 26 2007, 15:41 GMT

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