All Eyes On the Fed

Equity markets were generally firm last week in advance of the most anticipated Federal Reserve meeting in recent memory. The Fed meets this Tuesday to decide what, if any, changes are to be made to monetary policy. The markets have been convinced for weeks that the outcome of the meeting will be a cut in the Fed Funds rate of either a quarter or a half percentage point.

Sound-money advocates such as ourselves are still harboring a modicum of hope that the Fed leaves rates unchanged, but we recognize that is a very remote possibility and that a rate cut of some size appears to be a foregone conclusion. In our view, the most likely outcome is that the Fed will cut the Fed Funds rate by 1/4% point. Recession risks have increased sufficiently for the Fed to justify such a move. Moreover, the Fed doesn't want to expose itself to accusations that it failed to act if housing, economic, and credit conditions deteriorate from here.

There are several reasons we think a half percentage point cut is unlikely. First and foremost, the Fed is constrained by the inflationary backdrop. Core inflation, even according to the government's highly suspect method of calculation, has not been brought within the Fed's targets. Indeed, inflation pressures, which are the result of years of credit and money supply growth well in excess of GDP growth, are evident in a wide range of prices (e.g. food and energy; unit labor costs; health insurance premiums). The recent drop in the U.S. dollar index to new all-time lows provides irrefutable evidence of a continuing inflation problem that will limit the ability of the Fed to cut rates to stimulate the economy. A half-point rather than a quarter-point cut in the Fed Funds rate would create the destabilizing impression in the marketplace that the Fed has abandoned the fight against inflation in favor of a subsidy or "bailout" of excessive risk-taking and poor financial decisions.

Given that stocks have already benefited in recent weeks from expectations of a Fed rate cut (the S&P 500 is 7% above the lows reached August 16 - the day prior to the reversal in Fed policy), it is quite possible that the markets are set up for a "sell the news" reaction to Tuesday's Fed announcement. Markets will no doubt be volatile in the hours and days following the Fed decision.

Our strategy continues to be one of patience. Our sense is that the economy and financial markets are at a pivotal juncture, and we would assign roughly equivalent odds to positive and negative resolutions. In our view, the risks from the incipient credit contraction, the unpredictable housing bust, and the possibility of U.S. recession offset the historical positive of rate cuts by the Fed (with the 2001-2002 bear market being the glaring exception) and a supportive global economic backdrop. Given persistent inflation pressures, we wonder how much the Fed can cut rates, and how much good such cuts will do in solving the underlying problems of a glut of housing inventory and an excess of debt throughout the financial system.

Housing inventories are currently equivalent to almost 10 months of sales; home prices are likely to remain under pressure until this glut of supply is reduced by 1/3 to 1/2. Credit systems appear to have been expanded to their limits and now seem to be in a contraction phase, which Fed easing can cushion but not prevent. The coming weeks will be crucial for the credit markets as banks attempt to sell $300 billion of high yield bonds and loans linked to this year's record level of buyout activity.

The stock market, one of the best leading economic indicators, will tell us a lot in the next few weeks about the economic outlook. If the broad averages fall to new lows, and stay there for more than a few days, then the odds of a recession in early '08 clearly go up. Conversely, if recent market stabilization continues and the S&P is able to close and hold above key resistance at 1500, then the economy and market outlook will likely be on sounder footing.