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August 7, 2007
All eyes on the Fed
Later today, the FOMC meets to do what they do every six weeks or so...determine the target federal funds rate going forward. What will they do? What will the press release say? And what does it all mean? Those are going to be the questions on people's minds. Here's what a NY Times article, which quotes Jared Bernstein of the Economic Policy Institute says:
By taking a firm line in the current credit crunch, Mr. Bernanke can show investors that they cannot count on the Fed to save them from market swings, Mr. Bernstein said.
“This would be a good time for the Fed to impose some discipline on financial markets that we haven’t seen in a while,” he said.
But, in an illustration of the fine line that Mr. Bernanke must walk, Mr. Bernstein said he hopes the Fed considers lowering interest rates this fall, not to help Wall Street and hedge funds, but to lower the risk of an economic slowdown that would hurt middle-income Americans. With core inflation, excluding food and energy, running under 2 percent annually, the Fed has room to lower rates, Mr. Bernstein said.
By contrast, Jim Cramer wants Bernanke to save Wall Street. Check out the videos on Ritholtz's page too.
Fed funds options across the board are showing that the market is increasingly expecting the Fed to ease before the end of the year. The binary call option for December closed at 50 points today. Why it seems like just a few days ago it opened at 41. How I wish I had the sort of deep pockets to play in that market. Judging by the spread in the contract prices it looks like September...the next meeting after today... is where the market is increasingly putting its money. There was even some activity on the August contract as some traders are apparently hedging their position...just in case.
But any movement tomorrow is still a very long shot. The key will be the statement. Will they keep this language?
The economy seems likely to continue to expand at a moderate pace over coming quarters.
As the discussion of the latest GDP numbers showed, a lot of people believe that the economy will expand at a slower pace. The problem for the Fed is that if they change the language, it will cause a surge in the market as everyone re-evaluates their positions in light of the higher probability that the Fed will ease in September. It becomes a dangerous game of chicken if the Fed changes its language but doesn't follow through at the next meeting. How good is Mr. Bernanke's poker face? A shift in language now might as well be a rate cut now because it will be priced in by close of business.
Or, the Fed could retain the existing language. At the very least, this would be likely to provoke another tirade from Cramer. But seriously, this would lead to the market trying to guess whether Bernanke is playing chicken with them. We might see some disconnect in the bond market like we saw earlier this year. Ultimately, any rate cut, if and when it comes, will be more of a surprise, perhaps even an unscheduled one like in 2001. I wouldn't discount that as a mechanism that the Fed could use if they wanted to avoid the scenario of the previous paragraph.
Then there is this sentence from the last press release:
However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated.
But the latest inflation numbers were encouraging. At the moment, core inflation over the last 12 months has been under 2%, barely in the "comfort zone". Perhaps a modification of this sentence is in order, moderating the language just a bit. Truly, this is where a real target or a policy rule would be handy.
Finally, the sentence everyone will be looking at is this:
In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected.
This would have reflected the Chairman's outlook as recently as a couple of weeks ago when he visited Capitol Hill. Last week's numbers aside, there is likely to be a significant contingent in the FOMC who continue to see inflation as the larger risk. For them, even if growth slows to 1 or 2% in the remainder of this year, the potential to rekindle the inflation expectations is too great to risk on a rate cut now, or even the suggestion of one next month. Stay the course and continue to hope that the subprime mess doesn't totally unwind.
And it is that subprime mess that presents the critical test for the Fed. It is not their job to take away the risk of failure of these loans. However, their job is to ensure that it does not cascade into a problem of systemic risk. Willem Buiter has a point. Remind the firms that the discount window is open if they need liquidity to meet their obligations, perhaps even at a penalty rate (though that's pretty unlikely to be adopted in practice by this Fed). Be the lender of last resort, not the enabler of first resort. Wall Street won't like it, but it will be better than the alternatives.
As a student of the Great Depression, Mr. Bernanke certainly understands these issues well... better than most commentators gave him credit for a couple years ago. And for that reason, I think it is safe to say that the Fed will keep rates the same tomorrow and any change in language is going to be very subtle.
Predictably the market will overreact. Bonds might do some weird things for a while. That would not be new. And the Fed will continue to hope that it can pull it off again next month. In the meantime, we'll keep watching and waiting.
Posted by William Polley at August 7, 2007 12:15 AM
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Comments
Much more so than his predecessor, Chairman Bernanke seems to be much more aware of what the phrase "Moral Hazard" means.
Some people begging for a rate cut to "rescue" a stock market merely 7% off its all time highs is truly an absurdity.
Posted by: Barry Ritholtz at August 7, 2007 5:13 AM