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Fed Open Market Committee, December 11

Fri, Dec 7 2007, 09:24 GMT
by Luis Arregoces

BBVA Bancomer

• · Risks to economic growth have increased substantially
  
• · The probability of more rate cuts is higher
• · We expect a 25bp rate cut in the next FOMC meeting
  

The FOMC decided on October 31 to cut the fed fund rate as well as the discount rate by 25 bp. Following that decision, members seemed to have a neutral stance with respect to the economic outlook. As they expressed in the rate decision, “the upside risks to inflation roughly balance the downside risks to growth.” This assessment was to some extent reinforced in the meeting minutes; at that time, it became clear that many members considered the decision to be a close call.

However, less upbeat fourth quarter key economic indicators released since October 31, together with the evidence of severe frictions in money markets and the ongoing adjustment in credit markets has induced a significant change in the Fed evaluation of short-term risks to economic growth.

Vice Chairman Donald Kohn and Chairman Ben Bernanke explained the increased uncertainty regarding the economic outlook for 2008 in their speeches of last week. They expressed a growing concern about shortterm economic activity and heightened uncertainty regarding the nearterm outlook. In addition, Bernake explained that renewed turbulence in financial markets “partially reversed the improvement that occurred in September and October.

” Therefore, we see a heated discussion during the next meeting on whether to cut the fed fund rate by 25 or 50 bp; as their “risk analysis approach” tilts towards a rate cut to continue forestalling some of the adverse effects on the broader economy of the housing sector and the turmoil in financial markets.

We believe that FOMC members are confident that core inflation is contained and inflationary expectations are well anchored. Concerns about inflationary pressures could be the swing factor in the rate decision, leading the Fed to cut the rate by 25 basis points instead of 50 bp. At the same time, a cut in the discount rate of 50 bp, reducing the actual spread with the Fed funds rate from 50 bp to 25 bp, is possible. This action aims to address concerns regarding a liquidity shortage.

Rate cuts early next year are possible if evidence that the economy is going towards a sharp slowdown increases. We believe that the Fed’s communication could address the effects that uncertainty has on the rate decision and, to some extent, keep the door open to further cuts. We expect a rate cut of 25 bp in the next FOMC meeting.

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Published on  Fri, Dec 7 2007, 09:40 GMT