Can the Fed Really Afford to Cut Another 50-75 Points?

Includes: DIA, IEF, IVV, QQQ, SPY
by: Promod Radhakrishnan

Back in January when the Fed went ballistic by announcing a 75 bps cut & then a 50 bps rate cut within a span of 10 days, I thought it was an overreaction to the market's prevailing psychology.

A slew of recent economic developments indeed point to the risks associated with an overly liberal monetary policy. Per the latest price index releases, wholesale and consumer price indices continued to tread dangerous territory in January. Year-on-year, the January 2008 numbers are 4.6% over 2007 numbers. Oil continues to tread the 90-100 dollar range per barrel, and this does not create any room for inflationary pressures to ease. To add to the woes, the Euro broke a psychological barrier of 1.5 against the dollar last week (possibly accelerated by level-triggered program trading by currency desks)... which means imported crude oil turns even more expensive.

Finally, after a slew of such signals, there seems to be some voices of dissent in the Fed against a liberal interest rate cut policy. Vice Chairman Kohn and Chairman Bernanke continue to opine that growth is indeed the highest priority; but on Feb 29, Chicago Fed President Charles Evans mentioned that growth 'insurance' (read rate cuts) needs to be possibly reversed if inflationary concerns persist.

For one, the massive rate cuts in January did not do much to either ease credit availability or bring down market rates. Auction-rate bond failures highlight the fact that credit remains scarce - most of the big banks, including Citigroup (NYSE:C) & UBS (NYSE:UBS) shied away from such auctions, forcing most issuers to abandon the effort. Mortgage rates haven't softened either - 30-year rates have fallen as little as 27 bps from 6.07% to 5.80% over the past 6 months and 1-year ARMs have only dropped by close to 90 bps.

Credit and the cost of credit in the current market environment is being dictated more by lender worries. The biggest worry for all the big lenders at this point are a) potential write-downs in CDOs, MBSs, ABSs and other instruments which are either backed by sub-prime mortgages, ALt-A mortgages, risky retail installment/revolving debt etc. and b) potential risk associated with bond insurer downgrades and resultant massive write-downs in sub-AAA debt insured by them. The only way to tackle this is to use a double-pronged strategy of multi-party financial support for bond-insurers and incentive-driven/regulatory-driven measures to ensure continued credit availability. Sustained Fed rate cuts in such an environment may not work as much as expected.

As we wait for the next FOMC session on March 14, most traders are betting on another 50 or 75 bps cut. Chicago Board of Trade numbers already indicate a 72% probability of a 75 bps cut in March. And if January was an indication of how well the traders predict the Fed, we might very well be seeing that.

Hopefully not though - a more balanced view would mean the Fed looks at Feb. CPI numbers (released on March 14) and then weighs inflation risks against growth risks. Continued inflationary pressures will then dictate a lower cut of say, 25 bps. The market might react negatively to such a step, but how much should it matter? Has the market gained any stability after the last installment of liberal rate cuts? Definitely not!

In the current economic environment, the Fed should continue to focus on long-term economic fundamentals and not play into market psyche by announcing another 50 or 75 bps rate cut. If they do, it might just put us in a bigger problem of prolonged stagflation - making Fed monetary policy toothless.