Tim Duy on the likelihood that the Fed will cut rates in coming months:
Playing Chicken, by Tim Duy: Wow – what a week! One could almost forget that there was an FOMC meeting less than seven days ago. Ancient history as far as financial market participants are concerned, as the surge of Fed lending in the overnight market seemingly made the Fed’s stated inflation concerns seem almost naïve, moving up expectations, once again, for that inevitable rate cut. My caution is to remember that the Fed tends to act more deliberately than markets.
A sizeable portion of the rise in expectations for an imminent rate cut is clearly attributable to remarkably bad, sensationalistic financial journalism that fed into the turmoil. For criticisms, see Dean Baker and Calculated Risk, for example. The Fed’s actions last week did not constitute a change in policy. Note also that the use of mortgage backed securities as collateral is not new (although the size is impressive). Instead, the Fed was carrying out its stated policy objective – to keep the federal funds rate at its 5.25% target. Jim Hamilton provides a great summary of relevant analysis on this point, concluding with
The bottom line is that the Fed was doing exactly what it needed to do. But the fact that this was needed is a very troubling development.
A troubling development, indeed. Interestingly, I warned a couple of weeks back that the economy was likely to run into a period of turbulence that would cause a reevaluation of the Fed’s policy stance, albeit it happened a bit sooner than I anticipated. And so far, all the actors are playing their roles to perfection; with market participants clamoring for a rate cut while the Fed holds steady while making sufficient liquidity available to hold the fed funds rate at its target. Assuming the Fed sticks to its policy statement of just last week, policymakers will be hesitant to cut rates in an inter-meeting move, or even in the September meeting.
The only way to guarantee a rate cut is a continuation last’s week’s turmoil. But I am hopeful that the turmoil, at least in the US, subsided greatly by the end of Friday. Note that according to Bloomberg.com, the federal funds rate is sitting at just 75bp as we head into Monday morning. Once banks had an opportunity to catch their breath, it must have been apparent by late Friday that there was simply much too much cash sloshing around in the overnight market, and rates came down accordingly.
The Fed will now try to walk a fine line between reacting to the potentially negative real impacts of the recent repricing of risk and a fear of imbedding the financial system with additional moral hazard. The latter, I believe, will be especially important considering that Fed officials have been warning for months that financial markets were not appropriately pricing risk. Policymakers will be cautious about rewarding those traders now. My sense is that Fed officials would prefer to do their job and push liquidity onto the system when necessary, in a highly visible, “confidence boosting” splash, while allowing for the bad mortgage debt to reveal itself, rather than rush in with a rate cut.
Moreover, for the moment, the economic situation is vastly different to the environments of the most recent emergency rate cuts. The moves in late 1998 came in the midst of the Asian Financial crisis, the cut in early 2001 came after a long period of deteriorating conditions as the tech boom imploded, and the cut after the September 11 terrorist attacks stands in a class by itself. Clearly, economic conditions between those times and now are not remotely comparably.
Assuming the panic subsides in financial markets, the Fed will soon turn its attention back to the real economy. And on that point, my previous remarks still stand; economic activity will likely be sufficiently slow over the coming months to create an enormous amount of pressure on the Fed to cut rates. Here again I suspect the Fed will be playing chicken with the markets as they strive to look toward the other side of the slowdown.
Finally, note that despite last week’s turmoil being described by some as a “deflationary event,” the spread between the 10 and 2 year bonds stands at 35 basis points – a spread that is consistent will solid growth next year. If a true deflationary event were to arise, I think we would be expecting plunging yields on the long end of the curve. The yield curve also suggests that those looking for a hard landing and a massive Fed easing are likely to be disappointed.
In short, my expectations are that the pressure on the Fed to cut rates will likely ease from the “financial turmoil” story but grow from the economic story. The Fed will resist, especially if the unemployment rate continues to hover around 4.5%. The likelihood of a September rate cut has clearly grown, but I think the Fed will try to hold out longer. If the Fed does cut rates this fall or winter, I do not anticipate a long stretch of easing; the yield curve suggests just 25 or 50 basis points.
[Tim appreciates comments, or he can be reached at email@example.com.]
Tim adds an Update:
In today’s WSJ, Greg Ip, et al, clarifies the unusual aspect of the use of mortgage backed securities last week:
“the Fed last week encouraged dealers through which it operates to offer government-guaranteed mortgage-backed securities alone as collateral for short-term loans instead of the usual custom of using them with Treasury debt and bonds issued by Fannie Mae and Freddie Mac.”
They also arrive at the “it depends” story:
A serious deterioration in markets or spreading credit crunch could prompt a quick Fed move. Futures markets have priced in the possibility of a rate cut even before the Fed's next scheduled meeting, Sept. 18. If the situation doesn't improve, a Sept. 18 rate cut is likely.
But if markets stabilize and credit begins to flow normally, as Fed officials hope, the central bank is likely to hold its key rate at 5.25% a while longer to fend off inflation. The Bank of Japan is set to weigh rates next week and the ECB on Sept. 6.
Also, on page C1 is further discussion of the moral hazard dilemma:
"You don't want to see the Fed bail out these guys who have made a lot of money. They have made their bed and you want to see them lie in it," says a veteran trader at a New York brokerage house. "Then again, you don't want to see the economy go into recession."
That, in a nutshell, is the choice the Fed's policy makers face today.
Central banking is simply not easy.