• Additional pressures on inflation

• Lower marginal benefits of further rate cuts

• However, Fed will keep its options open

In its next meeting FOMC will probably reduce rates by 25bp. This move would take rates down to 2% confirming a deceleration in monetary easing that has gone from 75 bp cut in January, to 50bp cut in March, to our expected 25 bp cut at the end of April. Two factors justify this strategy:

  • 1. The inflation theme has reappeared in recent speeches this month. Governor Warsh stated that “increases in food and energy prices have pushed overall consumer prices and are putting upward pressure on core inflation and inflation expectations”, while Governor Mishkin reemphasized that “establishing a firm commitment to a nominal anchor can help stabilize output and employment”.
  • 2. Moreover, the positive impact of further reductions has diminished. With current nominal interest rates at 2.25%, the Fed knows that further cuts will have little direct impact on growth. As Governor Warsh stated “we must be careful to not ask policy to do more that it is rightly capable of accomplishing” given that “public liquidity is an imperfect substitute for private liquidity”. Furthermore, the main justification behind previous cuts was the need to support financial markets while navigating the credit/liquidity crisis, a situation which in words of Bernanke “has recently improved”. Board members recognize that the crisis is far from over, but the tone in recent speeches has shifted from the need for the Fed to provide liquidity to the need for Congress to get more involved and provide fiscal support. A very explicit example was a speech by Governor Krosner where, among several recommendations, he stated that “Congress can take another important step to facilitate greater use of loan modifications by moving quickly to reconcile and enact FHA modernization legislation permitting the FHA to increase its scale and improve the management of potential risks borne by the government”.

The logic in favor of 25bp rate cut is clear, but could FOMC decide to pause? The main reason not to pause is that it would send the message that the rate cycle has touched bottom. However, Fed is not ready or willing to send such a signal when, in words of Bernanke, the economy still faces downside risks due to the fact that “financial markets remain under considerable stress”. Thus, as long as the stress persists, members will be biased towards additional easing. In our worst scenario, rates may go down to 1.5%, while if conditions improve, FOMC could pause under a wait-and-see strategy, and even hike rates by year-end.