Apollo
Senior Member
Cash: $ 73.85
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Joined: 10 Sep 2007
Location: New York
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| What the Federal Reserve is likely to do tomorrow |
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The Federal Reserve will lower its key interest rate by 25 basis points on September 18th to 5.00%. Some investors even hope for a 50 basis point rate cut to 4.75%.
The main question seems to be the following:
Is it necessary for the Fed to act at all?
Most would argue that it is overdue and add that whatever the Fed will do will be too little too late.
Here are the reasons for a Fed rate cut:
•Employment has contracted in August and as one month doesn’t qualify as a trend the downward revisions for June and July show a clear slowdown in employment and a cooling of economic activity
•Partial economic data which points to a slowdown in economic activity
•The recent credit crisis
•The threat that the housing problems will spill over to other parts of the economy
Are there any reasons the Fed should keep interest rates on hold?
Yes there are more reasons for the Fed to keep interest rates on hold then for a rate cut.
•Selected sectors of the economy show strength
•Inflation, especially food based inflation, will start to put pressure on core inflation due to record high soft commodity prices
•Oil prices and other hard commodities continue to be at elevated prices and a rate cut could fuel inflationary expectations
•Prices Paid components of multiple surveys are near record levels for the year and suggest that prices won’t ease during the next six months in the current economic environment
•Inflation, headline and core, remain at or above the top end of the Fed’s expected comfort zone and have done so for an extended period of time thus remain embedded into the economic pipeline
The Fed has plenty of conflicting data and it depends on which data they will put more focus on it either paints a decent economic picture or a troublesome one.
The Fed needs to decide on one thing:
Which is the priority of the U.S. Federal Reserve?
Is it to bail out investors who did not see the credit crisis and housing problems or is it to fight inflation and more important inflationary expectations?
Is it more important to focus on what investors and regional banks want the Fed to do in the short-term or is it more important to focus on the continued weakness of the dollar and to provide long-term price stability?
Ben Bernanke mentioned that it is important to fix global trade imbalances. A rate cut would further weaken the dollar and make imports even more expensive which would cause the trade deficit to increase. Exports would be cheaper but the size of exports is smaller then the size of imports, hence the trade deficit, which means the negative impact of a weak dollar on imports compared to the positive impact of a weak dollar on exports is greater and therefore the trade deficit is likely to increase over the next few months.
The U.S. currently runs huge twin deficits and is heavily dependent on foreign investment. A rate cut would mean that foreign investors will receive a smaller interest payment on the heavy debt load they agree to carry and given the already high deficits could cause foreign banks and investors to look for other currencies outside the dollar.
Although this risk of currency diversification outside the dollar is limited due to the fact that the dollar is regarded as the global currency the U.S. continues to loose its position as the single most important economic power and other countries increase their global economic footprint. The risk is limited but should not be ignored as several countries are already in the process to look at other currencies due to heavy losses realized in their dollar investments.
There has been progress on the inflation front and currently we believe the Fed needs to keep rates on hold compared to our previous call for a rate hike but any premature rate-cut could lead to serious inflationary problems in the future.
The Fed should disregard short-term economic problems and focus on long-term price stability the same way their counterparts at the Bank of England and at the European Central Bank did last week. Both Central Banks left rates on hold.
Even if the Fed decides to cut rates by 25 basis points it will have limited if no impact on the current problems but rather have an elevated negative impact in the future if current trends continue.
Despite what the Fed will do over the remainder of this year we believe that the chance of a recession either by the end of this year or early next year has increased to 75%.
The fact that Central Banks around the world have injected over $200 billion into global markets in August to offer temporary relief to the credit crisis indicates that Central Banks have reached the limit of their capabilities and are in panic mode.
Central Banks should consider the long-term impact of their short-term problem fixing before they decide to act. The credit crisis won’t be solved by the fact that additional funds have been thrown at the problem but could have a greater negative impact in the future.
It is not smart to play it safe but it is safe to play it smart.
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