Handicapping the FOMC: The First Easing is Always the Hardest

What can we expect from the FOMC? For one, after Tuesday’s sell-off and the concomitant rush to the safe haven of the bond market, Fed Funds futures rallied moving forward the probability of a 25 basis point ease. As we can see from the table below (source: Bloomberg Professional Service) there is a 92% chance of a 25 basis point rate cut by August.

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The next four scheduled FOMC meetings are March 20/21, May 9, June 27/28 and August 7. Here is where we need to do some handicapping. First, I think that given the sub-prime mess and what is likely to be a baby with the bath water credit tightening reflexive reaction by lenders, I believe that we will get not only one but perhaps multiple easings this year. The first easing is always the hardest. This time around the first easing will be to remove that extra tightening from 5 to 5.25% from the FOMC last rate bump last year. The question is when?

Next week the FOMC doves will circle the wagons and begin the official dialogue to set up an ease, likely pushing the hawks out of the picture. I don’t think we get the cut but we get the message that they are willing to do so if the mortgage and credit markets continue to deteriorate. The Fed Funds markets indicate a 50/50 chance of an ease by July. I think the FOMC acts at the June meeting in what will be a mild surprise. By the end of the year we could get another 25 to 50 points of easing. The yield curve will level off and then slope upward very gently. This would set the markets up perfectly for a 2nd half rally.

Comments

[Bill Islava:]

Dear Scott, I do not doubt the Fed's may ease and reduce the interest rate to stimulate our weakening economy. However, by doing so would severely damage the US$. Additionally, the European Central Banks are looking like chesshire cats in raising their interest rate from 5.25 to 5.5% making all investors run for the exits (to dump their T-bills and US Gov't Securities) in favor of Euro bonds. It's a catch-22 and we no longer become the world's premier currency if this takes place. Either way, we darned if we do and darned if we don't. --Bill Islava

2007 Mar 15 01:27 PM

[Bob Misko:]

Bill,
I agree. With dollars sloshing around the world, the Feds are in a real bind. Did you notice the latest revisions to productivity (1.6%) and wage increases (6.6%)! These seemed to go under the radar, but to me this is alarming. This should force the Feds to RAISE rates in a prudent policy for inflation (and help the sagging buck).
This is likely to be accompanied by the world central banks balancing their reserves with (as you suggest) more euros. And other currencies (Yen?). Why would anyone hold dollar denominated assets, when their is a viable substitute now?
Thanks for your comments.
Bob

2007 Mar 15 02:41 PM