FOMC: Fed to Cut by 50bp in January

Overview:

In a speech last night, Fed chairman, Bernanke presented a significant shift in rhetoric. Bernanke set the stage for several more rate cuts during 2008 in his speech. Moreover, the wording of the speech suggested that the probability of a 50bp cut at the Fed meeting is now meaningfully above 50-50.

Details:

Bernanke devoted much of his speech to describing the reasons behind the problems in the subprime market and how the problems have spilled over into the broader financial markets and the economy. Further, he provided insight to the thinking behind the recent various Fed actions, which are attempting to relieve some of the distress in the money and credit markets.

However, the section on the economic and monetary policy outlook was by far the most interesting. The section reveals that the Fed has become increasingly concerned on the back of recent incoming information, which has indicated a worse-than-expected baseline for the activity outlook in 2008. Clearly, the Fed has been spooked by the string of negative data surprises: the ISM declining to 47.7, the weak labour market report, with a jump in the unemployment rate to 5.0%, and the continued sharp deterioration in new home sales.

In summary, there is now little doubt that growth is the predominant concern at the Fed. Specifically, the Fed seems increasingly concerned about the prospects for personal consumption, which has been the major driver of this expansion. Bernanke notes that higher oil prices, lower house prices, and declining stock markets, coupled with a potential deterioration of the labour market will weigh on US household spending.

Overall, Bernanke strongly indicated that further monetary easing is needed. He notes that the Fed is ready to take 'substantial action' and that the Fed will 'act in a decisive and timely manner' to counter threats to the economy or financial stability. Moreover, the speech suggests that the FOMC will adopt an outright easing bias at the next meeting, signalling more easing ahead. With this far more open-ended communication, the Fed will probably continue to ease policy until some signs of stabilisation show up in the data.

Assessment & Outlook:

Following the labour market report, we noted the risk that a 50bp cut could come onto the table at the January meeting (see Flash Comment - US: A knock-out labour market report). On the back of yesterday's significant change in rhetoric, the odds of a 50bp increase have increased meaningfully above 50-50. Hence, we change our forecast for the January meeting, now expecting the FOMC to cut interest rates by 50bp (previously 25bp). If we retain our original profile of 25bp easing at each of the remaining meetings during H1, this implies that the Fed funds rate will reach 3.00% (previously 3.25%) by the June meeting.

Speech by Chairman Bernanke on financial markets, the economic outlook, and monetary policy

Highlights from the speech

"Recently, however, incoming information has suggested that the baseline outlook for real activity in 2008 has worsened and the downside risks to growth have become more pronounced. Notably, the demand for housing seems to have weakened further, in part reflecting the ongoing problems in mortgage markets. In addition, a number of factors, including higher oil prices, lower equity prices, and softening home values, seem likely to weigh on consumer spending as we move into 2008."

"A second consequential risk to the growth outlook concerns the performance of the labor market. Last week's report on labor-market conditions in December was disappointing, as it showed an increase of 0.3 percentage point in the unemployment rate and a decline in private payroll employment. ... It would be a mistake to read too much into any one report. However, should the labor market deteriorate, the risks to consumer spending would rise."

"Even as the outlook for real activity has weakened, there have been some important developments on the inflation front. Most notably, the same increase in oil prices that may be a negative influence on growth is also lifting overall consumer prices and probably putting some upward pressure on core inflation measures as well."

"Monetary policy has responded proactively to evolving conditions. As you know, the Committee cut its target for the federal funds rate by 50 basis points at its September meeting and by 25 basis points each at the October and December meetings."

"However, in light of recent changes in the outlook for and the risks to growth, additional policy easing may well be necessary. The Committee will, of course, be carefully evaluating incoming information bearing on the economic outlook. Based on that evaluation, and consistent with our dual mandate, we stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks."

"Financial and economic conditions can change quickly. Consequently, the Committee must remain exceptionally alert and flexible, prepared to act in a decisive and timely manner and, in particular, to counter any adverse dynamics that might threaten economic or financial stability."

Danske Bank
http://www.danskebank.com/danskeresearch

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