FOMC Preview: How Far Will the Fed Go?

The biggest event risk this week is undoubtedly the Federal Reserve’s monetary policy decision on Wednesday. Now more than ever, the Fed’s decision could turn around the currency and equity markets. Since the last interest rate cut by the central bank on October 8th, the dollar has rallied more than 8 percent and the Dow Jones Industrial Average has fallen by more than 10 percent. The Fed’s half point rate cut at the time was a part of a coordinated effort with central banks from around the world including the ECB, the Bank of Canada, the Bank of England and the Swiss National Bank. With US interest rates now at 1.50 percent, the Fed will need to start rationing rate cuts going forward unless they want to take interest rates to zero.

Going into the FOMC meeting, economists can’t seem to agree on how much the Federal Reserve will cut interest rates. Of the 64 economists surveyed by Bloomberg:

53 percent expect a 50bp rate cut
26.5 percent expect a 25bp cut
19 percent expect interest rates to remain unchanged
1 lone economist or 1.5 percent of the people polled expect a 75bp rate cut.

Fed Funds traders appear to be more optimistic as they have already priced in 50bp of easing for Wednesday with a 32 percent chance of a 75bp rate cut.

The recent strength of the US dollar will add pressure on the Federal Reserve to make a larger interest rate cut but everyone needs to realize that the rate cut by the Fed this week will not be their last. Even though the national average of gasoline prices has fallen 35 percent, layoffs continue to rise. If GM and Chrysler (DCX) are forced to cut back or worse, pushed into bankruptcy, unemployment will continue to grow. The US economy is expected to get worse before it gets better and the Federal Reserve will not want to back themselves into a corner quite yet; a larger rate cut on Wednesday would give them less room to cut interest rates in December.

Here are the 3 most likely outcomes for Wednesday’s monetary policy decision:

Coordinated Rate Cut by the Fed, ECB and BoE (Dollar Bearish)

The best and most effective option for the Federal Reserve would be to coordinate a rate cut with the European Central Bank and the Bank of England. All three central banks would get the most bang for their buck by working together. Given Monday’s comments by ECB President Trichet about cutting interest rates again in November, he may not be opposed to making the rate cut one week earlier. The Times of London has also indicated that the BoE is under pressure to cut rates as well. This measure of solidarity would send a strong message to investors and at the same time not require the Federal Reserve to take interest rates below 1.00 percent, leaving them little room to cut interest rates later. A coordinated rate cut should be bullish for the global equity markets and bearish for the US dollar.

Independent 50bp Rate Cut from the Fed (Dollar Neutral)

Although a coordinated rate cut is the most effective option for the currency market, it may not be the most likely option because for whatever reasons, the ECB and the BoE may be opposed to coordinated intervention. Since an independent rate cut by the Federal Reserve is exactly what the market expects, the impact on the US dollar should be limited. The key will be the tone of the FOMC statement.

25bp Rate Cut (Dollar Bullish)

A 25bp rate cut will be a big disappointment to both the currency and equity markets. Given the degree of risk aversion and fear, we do not believe that Bernanke will risk the consequences of a disappointment since it could trigger another round of selling for stocks and high yielding currencies. In this type of market environment where investors are becoming immune to new measures taken by the US Treasury and the Federal Reserve, it pays to overdeliver.

75bp Not a Viable Option - Too Close to ZIRP

Even though Fed Funds traders are pricing in a respectable chance of a 75bp rate cut, we do not believe that this will happen because it is too close to zero. Zero interest rates come with a host of problems. If the economy worsens substantially despite zero interest rates, we will be experiencing a world of problems in rejuvenating growth. This situation can best be exhibited by the Japanese recession that ensued during much of the '90s. With interest rates at nearly zero levels, the BoJ found itself unable to stimulate growth with no policy tools available at its disposal. During this time the BoJ was forced to implement newly devised policy measures that had little if any effect on promoting growth. At the same time, a zero interest rate is also inflationary.

Although we believe that a coordinated rate cut would be the best option for the Federal Reserve if they want a good chance at stabilizing the markets, the fact that Trichet talked about cutting interest rates on November 6th specifically suggests that it may not be an option that he is seriously considering. If the central banks can work together, Wednesday’s rate decision could turn around the currency markets, but if they choose to respond with fractured rate cuts, risk aversion could remain a problem.

Comments

[Topcat:]

Could someone please explain WHY cutting rates now is going to help? The bank preferred stock with painful dividends to be paid to the government should get the banks lending again, so they can buy back the shares asap to avoid the dividend escalation. The banks, etc. have loan rates too high right now for mortgages, etc, with credit too tight and thus constricting business investment and home mortgages. We have to get them lending, so those people who DO want to buy houses now can do so. How does cutting rates help? It just moves down the dollar, right when it is rallying.

2008 Oct 28 12:44 PM

[Consider_this:]

The dollar would not be allowed to get too strong. The US govt never wanted a strong dollar. (Good for USA populace when they're saving, go on tours, or when they buy stuff at Walmart, but not good for people in power/various power interests)

Strong dollar will:
- Make debts denominated in USD (read: all of govt/corp/personal debt) more expensive to pay back.
- Make foreign countries less able to buy US goods
- Make DOW/NASDAQ more expensive to foreigners, so less flow of funds for investment
- Make multinational US companies lose profits, esp when they need to report their foreign earnings back as USD amounts.

A strong dollar will make it harder for any foreign countries/companies that borrowed in USD to repay their debt, but that was beneficial in the 1970's and no longer beneficial now. USA has went from a net creditor country to a net debtor country.

2008 Oct 28 01:06 PM

[steveballmer:]

... far too far!

2008 Oct 28 02:08 PM

[Kofi Bofah:]

According to your commentary, anything less than .50 will incite stock market panic. Even a cut of .75, will do nothing for stocks in the short-run, as a large group of investors are expecting the cut.

Are we entering Japan territory? 0% interest rates and 20 years of stagnation?

Are we in store for a repeat of this saga?
The Fed cut rates to 1% after Sept 11, and the smallish rates precipitated the credit boom and bust that we are struggling with today.

2008 Oct 28 02:10 PM

[bricki:]

Who cares? Lower fund rates isn't going to be a significant easing action. The US Treasury is pumping money into anything that can hold money using large fire hoses. The only thing that could possibly represent an easing policy would be for the Fed to start air drops of bags of money into all populated US areas.

2008 Oct 28 02:22 PM

[puddytat:]

Doesn't really matter much IMO. Americans should still be concerned about mad man Paulson giving away money to his buddies. He is gone in less than two weeks. Talk about a thank you present or what. Are Americans just asleep or what. The trough lineup done on a weekend .
Just keep people's eyes averted .... This action by Paulson will go down in history as the single biggest swindle of the largest group of people in the world.
Bush has single handedly gutted the US and now is off on a lifetime vacation with a sweetheart pension and tons of cash to do what he wishes while his country, and the world, goes down the tubes.
Swindlers. Who cares about Bernanke.. If he goes below 1% then what
Free money. Oh forgot... he already is doing that

2008 Oct 28 04:31 PM

[Smarty_Pants:]

"The economy is going quite slow."
Said the bankers controlling the dough,
A curvy young bimbo,
Tried to guess the FED's limbo,
And see just how low they would go.

2008 Oct 28 04:55 PM

[moonbat1775:]

There once was a banker Bernanke
well versed in all Fed hanky-panky.
He tried all he could
with paper from wood
but ended up without even a "thank ye".

2008 Oct 28 08:54 PM

[bbzz24:]

kathy you must be smoking something.
people in europe simply do NOT hang around at 7:15pm in their offices pondering rate cuts.
stop the dope, get a life as well.

2008 Oct 29 02:06 PM