FOMC Continues its Aggressive Easing Policy

• The FOMC cut rates by 75 basis points to 2.25%....
• ... as it for the first time in this cycle resists market pressure for still bigger cut...
• ....and two governors dissent in favour of less aggressive action, pointing to some rift inside FOMC.....
• .... markets react positively even if easing falls short of expectations, suggesting calm may return.....

Aggressive FOMC, but...

The FOMC continued its aggressive easing policy, as it cut again both the Fed Funds target and the discount rate by 75 basis points to respectively 2.25% and 2.5%, keeping the gap unchanged at its historical minimum. It was the second such unusual big step in less than two months, bringing the easing at 200 basis points since the start of the year and even at 300 basis points since the start of the easing cycle in September 2007. This kind of aggressiveness is exceptional and due to the combination of an unprecedented credit crisis and an economic recession. The Fed wants to prevent at any price the adverse feedback loop by which the credit crisis causes the economy to deteriorate, in which case the deteriorating economy again worsens the credit crisis, a vicious circle. It is also the implementation of its risk management policy, in which policy is set taking into account the consequences of the most negative scenario, even if such an outcome is maybe not the most likely one. The risk of a financial meltdown fits very well in this approach.

...two dissents show an unease with Bernanke's policy....

Two Fed governors, notably Fisher and Plosser, dissented in favour of a less aggressive action. There is an unwritten rule that only one, or at most two, governors may dissent to avoid the appearance of a divided committee and a weakened chairman. It is in recent years quite unusual that more than one governor dissents, as it occurred only three times since 1994. In the current difficult times and as the chairman Bernanke is only recently at the helm, a divided FOMC might be desastrous, as it could undermine market confidence. Both Fisher, who already dissented in January, and Plosser, who was always a candidate for a dissent are fervent hawks who are concerned about inflation and in previous months more than once expressed their unease in that respect. The statement didn't reveal the reasons for their dissent though. Nevertheless, we suspect that the Fed choose not to cut rates by the 100 basis points consensus expectation because of the inflation concerns of a number of governors. Possibly, there was one more voting governor that had some second thoughts about a still more aggressive easing, because of inflation concerns and was the 75 basis points a compromise to limit the number of dissents to two. More likely, some non-voting regional governors, who nevertheless participate fully in the FOMC debates, expressed dismay for a 100 basis points rate cut and had similar inflation concerns.

...on inflation concerns...

As a result, the Fed expanding much longer on inflation than in its January statement might be an indication that there was some more resistence against a 100 basis points cut than the two dissents suggest. Now, the statement not only says "The Committee expects inflation to moderate in coming quarters....", but it also states that "Inflation has been elevated, and some indicators of inflation expectations have risen" and "uncertainties on inflation have risen." The more prominent place of inflation might come into the Fed play should inflation continue to surprise on the upside, the dollar spirals further down and the credit storm blows over. However, we suspect these conditions will not be fulfilled in the near term.

However, FOMC more pessimistic on economy....

The FOMC says the outlook for economic activity weakened further, pointing to slowing consumer spending and softening labour market. It adds that tighter credit conditions and deepening housing contraction are likely to weigh on growth over the next few quarters. This is decisively more pessimistic than in the January statement, especially by adding "over the next quarters". This indicates that the Fed has left its expectation of an economic improvement in the second half of 2008.

....leaving the door open for more easing...

Weighing the economic and inflation risks, the FOMC still seems predominantly concerned about downside risks:

"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."

The only change versus the January statement is the reference to market liquidity (cf. bold part of the text), but the text continues to point to a continuation of the easing policy. However, worth noting, the Fed for the first time since the start of the easing cycle did not completely follow market consensus, creating a bit more room for them in the next months, without been "punished" by the market reaction, even if that may be simply good luck.

We keep our 1.5% forecast FF rate unchanged, but downside risks preveal

In our view, the current aggressive easing is mostly inspired by the risks for a financial meltdown and its impact on economic growth that has become ever clearer in recent weeks. We fully appreciate this risk, as it has been exactely the reasoning behind our agressive outlook for Fed policy since the summer of 2007. The recently taken unprecedented liquidity measures, the faillure of Bear Stearns, the ongoing stress in the financial system and an economy in recession all point to the need for more easing action, starting with another, probably 50 basis points, rate cut in April. We consider our target for a Fed Funds target bottom at 1.5% still as conservative.

Market reactions

The markets react positive to the Fed decision even if it fell short of the sky-high expectations for a 100 basis points rate cut. It was a gamble, but the Fed seemed to have well read the markets state of mind, helped though by the better results of Goldman and Lehman released earlier today. So, equities rebounded after some modest post-FOMC selling and pushed equities to major gains for the day. The Treasuries paid the price with yields higher and the curve bearishly flatter, as the short end led the sell-off. Also the dollar gained substantial ground against euro and yen. The violence of yesterday's moves should, of course, be seen in the context of extreme positioned markets. Markets may now have entered calmer waters going towards Easter, .....unless another credit event decides otherwise.

March 18 FOMC statement

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 labor 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 leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. 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.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Gary H. Stern; and Kevin M. Warsh. Voting against were Richard W. Fisher and Charles I. Plosser, who preferred less aggressive action at this meeting.

In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 2-1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, and San Francisco.

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