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Friday, January 18, 2008

Fed Watch: Odds Still Favor a 50bp Cut

Tim Duy says the Fed is likely to cut rates a half point:

Odds Still Favor a 50bp Cut, by Tim Duy: I am inclined to believe that Bernanke & Co. intend to cut rates 50bp on Jan. 31. Bernanke’s move to a more blunt communication strategy, however, has shifted market expectations to a debate between 50bp and 75bp. While I think a 75bp rate cut will be in play at the upcoming FOMC meeting, I think the odds still favor the 50bp rate cut.

I am trying to maintain a baseline assumption about Federal Reserve policy objectives –fundamentally, the Fed wants to make their medium term forecast meaningful and relevant from a policy perspective. Returning to Fed Governor Frederic Mishkin’s speech last week:

I think there is too much focus on what decision will be made about the federal funds rate target at the next FOMC meeting (Mishkin, 2007e). What is important for pricing most financial assets is the path of monetary policy, not the particular action taken at a single meeting. For these reasons, I hope the recent enhancements to the Federal Reserve’s communication strategy--especially the greater prominence of the macroeconomic projections of FOMC participants--will help shift attention toward our medium-term objectives and our approach in meeting these objectives.

I have already argued my position that the Fed’s medium and long run forecasts imply a neutral Fed Funds rate in the range of 4.0 to 4.5%, and that the Fed would like to anchor expectations around that range. They do not want to continue the policy see-saw of the last decade.

My next assumption is that the flow of economic data will tend toward weakness for the first part of this year and that the Fed will find it virtually impossible to resist responding to that weakness. That argues for continued rate cuts for at least the next four meetings, barring some miraculous turnaround in the data. The Fed simply cannot sit back and do nothing.

My final assumption is obvious – no amount of rate cutting now will have any affect on the flow of data in the near term. Fed Chairman Ben Bernanke knows this; hence his support for immediate fiscal stimulus. The next 100bp of cutting is about what the economy looks like in January 2009, not now.

If the Fed pulls the trigger on 75bp at the end of next week, they will be on the path to a minimum of 150bp in the first half of this year – 75bp in January and 25bp in the each of the next three FOMC meetings (I think 100bp is more consistent with the Fed’s supposed policy objectives). This would go along way to meeting the Goldman Sachs call of 2.5%, or a full 200bp below the Fed’s estimate of neutral and 275bp below the last peak. The see-saw continues and any efforts to tie policy to their supposed medium and long term objectives are essentially meaningless.

Of course, the Fed could reverse course rapidly in the latter half of this year, unwinding the excess stimulus. Personally, I have virtually no faith in the Fed’s willingness to reverse rate cuts – regardless of the rate or direction of inflation – during a period of economic weakness.

Moreover, while the negative tone of recent data continues relatively unabated, it is not quite as dismal as the business press would lead us to believe. Not that I see roses where others see weeds. Instead, I sense that tenor of the data speaks more to 50bp than 75bp even if the Fed intends to front load additional policy. The industrial production report was not yet consistent with the ever increasing recession calls (although the Philly Fed report was decidedly weak). Nor was the most recent read on initial unemployment claims, which should be accelerating if we are actually in recession.

I had a similar reaction to the retail sales report as Jim Hamilton. Wasn’t great by any means, but not the end of the world either. But I wasn’t excited by the November strength in retail sales in the first place, and the December numbers are largely just matching my expectation that consumer spending looks finally to be ratcheting down. Indeed, January’s rise in consumer confidence is consistent with year-over-year growth of real consumer spending somewhere around the 2% rate I keep expecting to see and is inconsistent with economic freefall. Finally, the drop in the inventory to sales ratio in November is very inconsistent with the recession story.

Then there is housing. I have no need to comment on the state of the housing market itself – the numbers speak for themselves and are a significant part of the reason that the Fed will be induced to continue cutting interest rates.

Not to say that there is no argument for 75bp. In the grand scope of things, what’s another 25bp, especially if you expect to cut rates at least that much anyway? And while in December the Fed was sufficiently confident of their outlook to disappoint market participants looking for the more aggressive of the rate cut options at the time, they may not feel the same liberty given the renewed market instability we have seen this week.

Bottom Line: I think odds still favor 50bp – it would be more consistent with the Fed’s medium term objectives, and help maintain policy flexibility over the first half of the year. Moreover, this cut will do nothing to support the current environment, and the Fed needs to be looking at what it means for 2009. The case for 75bp relies largely on meeting market expectations, expectations that may be driven by an excessive level of fear.

    Posted by on Friday, January 18, 2008 at 01:12 PM in Economics, Fed Watch, Monetary Policy | Permalink  TrackBack (1)  Comments (15)


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