Tough Decisions: What the Fed Should Do this Tuesday

Includes: DIA, QQQ, SPY
by: Stock Traders Daily

There's more than just the Fed meeting this week, but first things first:

The last time the FOMC felt this much pressure from the Market, right after Robert Rubin explained to Bernake just how severe the problems in the credit markets were, Bernake cut rates by 50 basis points. That's what the street is expecting now too. Wall Street is turning up the heat on the FOMC, and traders want the Fed to support the Market; they want a 50 basis point cut, and Wall Street thinks they can influence this Fed Chairman enough to get it.

They might get some, but they are unlikely to get all that they hope for. In fact, they are probably going to get more (other things) than they bargained for.

The FOMC will almost surely cut interest rates by 25 basis points on Tuesday. This is just about assured. If the FOMC decided not to cut, that would be a big blow to the Market, and although inflation concerns exist, Fed Governors have already made statements which suggest that inflation is less important than future economic conditions at this time. Therefore, the FOMC is likely to cut some, but are they likely to cut 50 basis points?

Inflation is a clear concern across the globe. If we are truly a global economy, then the FOMC knows that inflationary pressures exist on a worldwide basis which will impact the costs of Core PPI prices first, and eventually Core CPI prices as well. We are not talking about food and energy prices here, but those are the underlying culprits.

In addition, with relatively solid current economic numbers, does the FOMC have enough fuel to cut rates aggressively right now, or are the big boys just looking for another boost so that they can sell into strength again (read my article about the Market's correlation with the fed funds rate to learn that the Market follows the trend of the Fed Funds rate, not the opposite)?

I don't think that the FOMC has enough reason to cut by 50 basis points at this time, but I expect 25. If Bernake cuts by 50 basis points he will have proven that he indeed will take action at the whim of Wall Street and his presence as a leader will be diminished accordingly.

What should be done:

  • Cut by 25 basis points
  • Acknowledge that inflation risks exist
  • Make it clear that economic conditions are likely to worsen.
  • Make it clear that additional cuts will come if needed.

Anything divergent from that will not be good in my opinion.

Later in the week, when PPI data is released, I expect higher prices in the Core PPI level, but I am not expecting those pricing pressures to show up in the CPI yet.