FOMC Caught In a Catch-22

 |  Includes: AGG, DIA, SPY
by: Stock Traders Daily

A rate cut by the FOMC is now expected.

This would be a proactive step by the FOMC in my opinion, but a risky one. It may not even work because rate cuts take a while to impact the economy, and the recent increases in rates in the credit markets were based on risk assessment, not anticipated changes in rates.

The main reason that I see for a rate cut is the bump up in mortage payments that are going to occur in the next couple of months. If the Fed eases a little these bump ups will be less of a burden to the borrowers and the foreclosure rate that we all anticipate will be lessened. This will help the economy avoid a more serious issue, but the severity of the issue wil still exist. There is no way around it.

The risk is that the lower rates make current debts less of a burden (credit cards) and that may pave the way for inflation to re-enter the picture. Again, I see no signs of it now, but what if....

The cost of corporate financing is clearly going up (even if rates get cut the costs are still much higher now than they were just a few weeks ago). This is not based on interest rates, it's based on risk assessment. Companies would love to pass this along to the consumer, but up until now they have had no pricing power. The main reason is that consumers have been living off of debt and savings (negative savings rate) and thay have been unwilling and unable to pay more. However, if those debt burdens are suddenly lowered (credit card payments go down) consumers will have more of an ability, and willingness to pay more for goods and services. Pricing power could re-enter the Market, and the companies could pass on these higher expenses accordingly.

Inflation then would become an issue. Consumer sentiment would be a key indicator for the future prospects of the economy if interest rates are cut. However, it would be a reverse indicator. If rates are cut I would want to see weak sentiment numbers to thwart inflation. A strong sentiment would mean that the consumer doesn't mind staying the course, and spending every excess penny he has. That would bring inflation back. If rates are cut watch sentment closely as a gauge of inflation.

The risk is clear, but the impact of a cut is not. Will it really help a Market whose rates are increasing based on the risk component?

Proactive steps are good...but the FOMC now seems caught in a catch - 22.