FOMC Decision: Gliding To Neutral, One Last Easing

Today the Fed lowered its target federal funds rate by 25 basis points to 2.00 percent. The move was expected by the markets. Yet the Fed also kept its options open as evidenced by their concerns about growth and liquidity. The Fed's bias to ease remains in place with concerns on credit, housing and labor markets. Inflation remains secondary.

"Economic Activity Remains Weak"

Over the last three years, job gains have slowed steadily and in the last three months employment has experienced outright declines. These declines are consistent with weaker personal income growth and consumer confidence. The Fed dropped its reference to "downside risks to growth" and instead cited "that economic activity remains weak."

"The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability." This suggests that the Fed remains ready to respond to the weak economy. While we anticipate a pause in this easing cycle, bias on policy remains toward easing. Going forward, we will focus on jobless claims, the ISM reports, factory orders and building permits/home inventories as indicators of where the economy is headed in the short-run.

Inflation Remains an Issue

Two dissents were registered to the Fed's easing decision. Both came from President's Fisher and Plosser who also dissented at the prior Fed meeting. We suspect their concern was that further Fed easing would increase the risk of rising inflation later this year. As illustrated in the middle graph, the core personal consumption deflator remains at the top end of the perceived target range of 1-2 percent. Moreover, our outlook for the remainder of this year suggests that inflation remains at or slightly above the top end of the target range.

"Inflation expectations have risen... " according to the Fed's statement. Therefore, it appears that the Fed simply weighted their concerns on weak growth greater than on rising inflation. Effectively, this also limits the extent of any further easing given the pickup in inflation expectations.

"Financial Markets Remain Under Considerable Stress"

As evidenced by the TED spread (LIBOR less Treasury bill yield) in the bottom graph, the credit risk premium in the short-end of capital markets has been reduced in recent months but remains elevated. In part, wider risk premiums are a welcome sight to reverse the lack of apparent risk assessment for the first half of last year. The blow-out premiums of the August to November 2007 period reflected a wholesale aversion to credit that hindered economic activity in the fourth quarter. Going forward, risk premiums are expected to decline moderately while the economy still works through the residue of exuberance.

We expect the Fed will use their auction facilities as the primary means to supply liquidity to financial markets. Leaving adjustments to the Fed funds rate as a means to respond to inflation and growth expectations.

Wachovia Corporation
http://www.wachovia.com

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