Fed Rate Cuts Increasingly Likely, But Will It Matter?

by: Tim Duy

This week’s data flow only confirms what was apparent last week – the US economy deteriorated as we headed into the third quarter. By now, there should be no doubt that the US consumer is devoid of resources to further propel spending. And without an active consumer, the US economy will undoubtedly stagnate, especially since the rest of the world appears equally reliant on the US consumer.

Such persistent weakness would traditionally prompt additional rate cuts on the part of the Federal Reserve, but I suspect interest rate policy has largely lost effectiveness. Starting with the mortgage meltdown that began last year, credit channels have become increasingly impaired despite aggressive rate cuts.

The credit explosion of this decade has proven unsustainable; you cannot borrow your way to prosperity. The US economy is undergoing a structural adjustment that the Fed can only cushion, not stop.

Monday brought the personal income and expenditure report for August, which indicated that consumption expenditures will be negative in Q3 for the first time since 1991, a point pounced upon by commentators (here and here). Interestingly, private wage and salary growth continued to defy gravity (click chart to enlarge):

Ratecut

Over the last year, however, inflation has destroyed any nominal wage gains. Lacking sufficient savings to compensate for inflation, and cut off from the housing ATM, consumers are reduced to living within their real incomes for the first time in years. It hurts.

Federal stimulus masked the damage during the second quarter, but the effect was only temporary – indeed, the economy deteriorated at a startling pace as soon as the checks stopped coming.

The ISM manufacturing survey highlighted the extent of the deterioration, with a plunge in the headline number from 49.9 to a recessionary level of 43.5 amid a stunning drop in new orders. With the exception of rapidly diminishing price pressure as commodity prices faltered, there is no positive spin one can place on this report.

Indeed, this is the type of report that traditionally triggered rate cuts; the lack of such weakness has been an anomaly in the current policy cycle. Manufacturing weakness is aggravated to no small extent by the collapse in auto sales. Again, a stunning decline, but not entirely unexpected given the strains on household budgets. As long as your existing car still runs, a new car is one of the easiest items to forgo.

If you are counting on a housing rebound to cure the nation’s economic ills, you were once again disappointed with the Case-Shiller report. The decline in housing prices continues seemingly unabated.

I am amazed by the number of commentators who believe that fixing the nation’s economy is as simple as restoring confidence in the housing market. I very much dislike the argument that confidence is the problem. It makes me feel like I am in Oz, and that all that we need to do is collectively click our heels together, saying “I want to go home,” and suddenly it will be 2004 and we can expect our homes will appreciate 15% a year, risk free.

A more likely reality: Housing prices will contract until those prices are consistent with traditional underwriting conditions and incomes. Here I agree with Barry Ritholtz – policy should not be focused on trying to raise asset prices, but instead to cushion the blow from the reversion of those asset prices to the values determined by social conventions, which, in this case, is ability to repay the mortgage.

In the wake of this week’s House 'No' vote on the bailout package, the Federal Reserve is inching closer to lower interest rates, although such a move is more likely to occur at the October or December meeting rather than in the intermeeting period.

I doubt the Fed ever expected to cut rates further; they were hoping for a rapid passage of a bailout package to bring quick relief to credit markets. No such luck; each day that passes, more damage is done. Atlanta Fed President Dennis Lockhart summed up the situation with a rather dour assessment:  

Overall, the outlook for inflation may have improved, but prospects for growth have weakened. Importantly, I believe problems in our financial system add significant risk to the downside for the economy.

He did note that he was assuming the bailout plan was dead, although such predictions were obviously premature given last night’s Senate vote.

But the recent market upheavals have already done significant damage regardless of the bailout; comprehensive action is mostly about containing the damage at this point. And note that the August data that started trickling in the end of last week was largely pre-most recent crisis.

Adding to Lockhart, arch-hawk Philadelphia Fed President Charles Plosser shifted his position notably and opened the door to a rate cut. From MarketWatch: 

A Federal Reserve official who twice voted against interest-rate cuts earlier this year said he'd be open to supporting further decreases in the Fed's federal funds rate target if required.

In an exclusive interview with Market News International, Philadelphia Fed President Charles Plosser said he believes the economy is "more resilient" than many believe in the face of the worst post-war financial crisis, adding that people need to "take a step back and take a deep breath."

But he did indicate that if credit conditions worsen to the point that the economy is imperiled, he'd vote to cut rates.

That’s right – a collective deep breath and our confidence will return. And the bad assets will suddenly disappear. And we all wake up in the morning back in Kansas.

Bottom Line: If Plosser is willing to consider rate cuts, it is a fair bet most of the FOMC is already there. Still, a cut at this juncture may just be doing something to do something.

If the Fed sits tight through the rest of this year, they simply have come to the conclusion that rate cuts are ineffective at this point. Does anyone really believe that another 50bp will have anything more than a marginal impact?

As long as the credit markets are impaired, rate cuts are almost a sideshow. Without a mechanism to channel large amounts of dollars to consumers, or some other sector of the economy, the Fed can drop rates to zero with little impact.

The price of money only matters if you can get some, and getting some is hard to do when the financial sector is deleveraging in an attempt to save itself.