FOMC: Bernanke Takes Charge of Markets
Overview:
Yesterday evening (March 18), the Federal Reserve Open Market Committee (FOMC) decided to lower the Fed funds rate by 75bp to 2.25% - less than our and the markets expectations of a 100bp cut. Even so, this policy action should be perceived as a very aggressive move, in our view.
Unusually, the committee seemed split on the decision. Two local Fed governors, Fisher and Plosser, dissented preferring a less aggressive action. Moreover, only three of twelve district banks applied for a corresponding 75bp cut in the discount rate to 2.50%. Despite the disagreement about the size of the interest rate cut, the committee has maintained a clear bias toward further easing.
Market reaction:
On the back of the more hawkish than expected outcome, the market reduced its expectations for future policy easing. The market now predicts an easing in the Fed funds to a little less than 1.75% by mid year. As such, the initial market reaction was for higher bond yields and a stronger dollar. Equity markets resisted the disappointment and gained further following the policy announcement.
Details:
Generally, the statement leaves little doubt that the FOMC remains highly concerned about the economic outlook by noting that "the outlook for economic activity has weakened further". Moreover, the financial stress, tighter credit, and a deepening of the housing correction is expected hold back growth in the coming quarters.
Surprisingly, the committee elaborated very carefully on the inflation risks this time around. In particular it acknowledged that 'some inflation expectations have risen', 'uncertainty on the inflation outlook has increased, ' and 'it will be necessary to continue to monitor inflation developments carefully'. Generally, this indicates an increasing concern among some members about 1) the recent unfavourable development in many inflation measures, and 2) whether the Fed is risking a de-anchoring of inflation expectations by its super-aggressive easing strategy.
The forward looking part of the statement leaves little doubt that the Fed continues to be biased towards further easing. That said, there are important signals that the Fed will be moving forward in a more cautious manner. Firstly, it was a bold move by the Fed to disappoint the markets in the current environment. Secondly, the dissents by Fisher and Plosser indicate that the committee has been very split on the decision and that discussion has been standing between easing 50bps or 75bps, not between 75bps or 100bps. Finally, the majority of the local district banks did not apply for a 75bps cut in the discount rate.
Generally, yesterday's action indicates that the Fed is not willing to satisfy market expectations at any level or at any given cost of long-term credibility. Moreover, this is a signal that the FOMC is now willing to take charge of market expectations in an attempt to avoid being forced into an undesirable steep path of monetary easing, which could have reputational costs.
Assessment & Outlook:
With recent events indicating the severity of the financial problems and increasing evidence of an economic recession, the FOMC is likely to ease interest rates further during H1. Moreover, nothing in yesterday's statement suggests that the FOMC's fundamental concern on growth and financial stability has eased. This leaves our standing projection of a terminal rate of 2% by June somewhat too high.
As we will emphasise in the new edition of Global Scenarios (published later today), we expect a continued deterioration of economic data during H1 before fiscal and monetary stimuli act to stabilise the economy at some point in H2. Against this background, we add 50bp of further easing to our forecast. Hence, we now forecast a 50bp cut to 1.75% at the April meeting. This, we believe, will be followed by a terminal cut of 25bp to 1.50% at the June meeting.
Current statement (March 18, 2008)
The Federal Open Market Committee decided today to lower its target for the Federal funds rate 75 basis points to 2-1/4 percent.
Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labour markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.
Inflation has been elevated, and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, reflecting a projected levelling out of energy and other commodity prices and an easing of pressures on resource utilisation. Still, uncertainty about the inflation outlook has increased. It will be necessary to continue to monitor inflation developments carefully.
Today's policy action, combined with those taken earlier, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will act in a timely manner as needed to promote sustainable economic growth and price stability.
Previous statement (January 30, 2008)
The Federal Open Market Committee decided today to lower its target for the Federal funds rate 50 basis points to 3 percent.
Financial markets remain under considerable stress, and credit has tightened further for some businesses and households. Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labour markets.
The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.
Today's policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.
Danske Bank
http://www.danskebank.com/danskeresearch
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