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The Fed meets today and the markets are pretty much pricing in the status quo with some saying that powerful central bank will be more hawkish than previously stated.

This sentiment has been in development for a few weeks as the Eurodollar markets for December 2007 and 2008 settlement tightened back to the 5% level (implying just one cut at this point). When the treasuries were on the move lower at the beginning of this month, each of these contracts were in the process of pricing in 3 cuts for 2007 and now each has only one cut on the table.

Strong Growth Model
But in a way, this change in sentiment was inevitable. There are several measures I use to examine the economy. First is my growth model. In short, it has been robust. The indicator has been at or around 20% since the latter parts of August. Over the past 7 years, the Fed has rarely cut rates when this indicator sits in the 20% range.
Housing
On the other side is my prices model which averaged 15% this year till the latter part of August when it started to descend (and is now barely positive year over year). Combined, real growth is strong. Further, fair value of the Fed funds target sits slightly higher at 5.49% which means the Fed is easy at the moment, helping growth. So rising growth, stabilizing prices and easy policy should facility the economy.

Housing Will Moderate, But Not Collapse

Many have said that the housing market will drag on the economy as it “collapses.” I do not believe the housing market will collapse. It will moderate and prices will fall but for it to collapse, the economy would have to slow dramatically from the current pace.

Furthermore, while job growth has been less than robust, the net result of the job creation plus earnings is positive and adds to consumer spending and disposable income which, in turn, eases the mortgage burden. Also, my own housing indicators, one called the housing health indicator, is actually getting better after trending down for almost 2 years. Combine this with the action in the homebuilders and conditions are stabilizing, not destabilizing.

This is not to say that the Fed should hike rates at the moment. While I have indicated that the Fed is easy, it is this way for a reason – to help housing get off its feet. In addition, with prices (in real time from the market) trending lower (y/y) from my models, a hike at the moment would speed up the price trend which I think at the moment, has an appropriate pace. Further, a hike at this point, would put the housing market back no its feet once again, and take away the stable conditions. If the current policy is working in moderating prices and enhancing growth, then there is no need to hike rates today.

So what will the Fed do? Well, I am in the camp that they will argue that inflation is a problem but it is also an indicator that the risks to growth and prices is balanced – like their previous statements.

Going forward, I think they will adopt a policy much like the Bank of England did when their local real estate markets slowed (dramatically). Keep policy steady, let the housing market catch its breath and once that is achieved, move to higher rates to balance out prices. Where is the Fed in regards to this scenario? I would argue in the first 25% which means that policy may be on hold for sometime.

Related ETF: SPDR Homebuilders (NYSEARCA:XHB)

Source: What Will the Fed Do?