FYI | Sep 19 2007
By Greg Peel
The statement (emphasis added by FNArena):
“The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 4-3/4 percent.
“Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.
“Readings on core inflation have improved modestly this year. However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.
“Developments in financial markets since the Committee’s last regular meeting have increased the uncertainty surrounding the economic outlook. The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.”
Prior to the Fed’s action last night there had been some tenuous signs that a frozen credit market had begun to thaw slightly. However, this clearly wasn’t enough for the Fed to decide the market could work things out for itself. While some quality commercial paper issues had started to roll over, asset-backed paper was still well and truly frozen. LIBOR rates had stabilised, but uncertainty was still clear. And then came Northern Rock.
The panic caused by Northern Rock’s approach to the Bank of England for emergency credit would not have been lost on the Fed. Northern Rock only set up the emergency line – it still hasn’t drawn on it. But ugly scenes outside regional branches, and a flow on a panic into other British lenders, prompted the BoE to go back on its original statement that it would not bail out the financial market. Originally only smaller Northern Rock depositors would have been fully protected by BoE guarantees. But the situation got well out of hand.
This prompted the BoE to advise the Treasury that unprecedented emergency action was needed to stop the run on Northern Rock. The Chancellor responded by not only guaranteeing all Northern Rock deposits, but all deposits in banks qualifying for lender of the last resort facilities from the BoE. This has never happened before.
At the end of the day, panic is an illogical beast. While the Bank of England had no desire to rescue a foolishly overleveraged financial market, panic in the streets from the masses was not going to be averted by mere conciliatory actions. Action had to be taken that was swift and decisive.
(Note the panic that spread to Australia yesterday: Adelaide Bank is going under! The sky is falling !)
The Fed has been faced with the same dilemma. The market was already expecting a 25 basis point cut. There was a risk that to cut by only this amount would be to solve nothing. It was inherently possible that credit markets would simply anticipate a further cut down the track, and thus hold off any lending until that cut – or the next. The Fed needed to send a message to quell the panic definitively. It chose a larger than normal rate cut as an attempt to send this message.
It also cut the discount rate by 50 basis points. This move was also widely anticipated, although many a commentator suggested the Fed might cut the target rate by only 25 points and then bring the discount rate into line with a 75 basis point cut – ie, both rates at 5.00%. While the Fed target rate affects only the rate at which banks will lend to each other overnight, the discount rate is the rate at which the Fed will lend directly to stressed institutions. The result of a 50/50 cut is that the latter rate remains at a 50 basis point spread above cash (5.25% versus 4.75%) – still an effective penalty.
It now remains to be seen whether the 50 point target rate cut will spark banks into confidently lending to each other once more. It remains to be seen whether more institutions will come to sort their problems out at the discount window. Before last night, neither Fed cash injections (which had already lowered the target rate by proxy) or the discount rate cut had had much impact. One thing is certain, however, and that is adjustable rate mortgages are mostly already set in stone. Existing mortgage holders will not benefit directly from the rate cut.
Like the Bank of England, the Fed was initially reluctant to bail out a greedy Wall Street and even mindless subprime mortgage holders. But it noted in its statement that the “tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally”. In other words, to allow the markets to reprice risk and suffer the consequences had become too big a risk to Greater America. A recession loomed.
“Developments in financial markets,” said the Fed, “have increased the uncertainty surrounding the economic outlook”. To that end the committee decided to step up a gear and become more definitive in its language. Prior to last night, the Fed had more than once said it was “prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets”. But last night it said it “will act as needed to foster price stability and sustainable economic growth”.
Before it was looking merely to mitigate. Now it is looking to achieve price stability and growth. Only a 50 point cut was going to achieve that.
The problem with such a drastic cut is, however, its inflationary effect. By dropping the target rate the Fed is as good as saying we will print as many US dollars as we have to to save our economy. The US dollar responded accordingly by falling against every major currency except the yen. The yen was an exception, because price stability means the world is free to start carry trading once more. But the gold price has soared once more, suggesting to the world that inflation is a very real risk.
Having ignored the question of inflation in its August 17 statement (when it first cut the discount rate), the Fed returned to the issue last night suggesting “inflation risks remain”. But inflation in the US is running at comfortable levels so far. From this point on there are conflicting forces: the housing market is deflating, but the prices of oil and grains are skyrocketing. By cutting rates the Fed devalues the US dollar, which in turn automatically increases the US dollar value of commodities. Thus the Fed will “continue to monitor inflation developments carefully”.
This statement suggests that what the Fed has given, it could take away again at the first signs of a return to the old problem. But not everyone believes that the current problem has now been solved in one fell swoop.
Balancing out the euphoria on Wall Street overnight was the inevitable question of “What does the Fed know?”. Bank Paribas noted:
“The FOMC through its vast network of business and banking contacts clearly processes more information than is generally available to the public. They also possess the most sophisticated models of the US economy. Their models must have been signalling sharply rising risks of serious economic dislocation after they inserted some of the anecdotal information about tightening credit availability into their models. It must have made them wince as they lowered rates by more than the market was pricing in.”
The Fed said:
“Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.”
To which Paribas responded:
“The key is that this action forestalls only some, not all, of the adverse effects to the economy, and therefore more action is needed to forestall others. In addition, they are now anticipating that they can produce only moderate (below trend) growth over time. Adding ‘over time’ suggests they anticipate much slower than below trend growth in the immediate future.”
On that basis, Paribas is assuming that this cut will be “the first among many”. Many further cuts will still be needed to prevent the US economy from heading into recession. The Paribas economists are not alone in this prediction.
On the other hand, others in the market have now deemed the crisis to be over. Before the Fed rate cut, the consultants at GaveKal declared the global credit crisis over given the unprecedented extent of the Bank of England rescue of Northern Rock and the Treasury’s guarantee of all bank deposits. Respected Australian market analyst Ian Huntley has this morning declared:
“The Fed’s action last night in cutting its key rate, the Fed Funds Rate, by 0.5% ends this current correction. It also marks the start of the next leg of this bull market, which should run well into next year and possibly into 2009.”
In making its decisive move last night, Ben Bernanke may well have become a hero. Mind you they called Alan Greenspan a hero in 2003 and now much of the world blames him for the crisis we’ve found ourselves in. By easing monetary policy once more, has Bernanke simply handed heroin to a drug addict? Can the global economy be saved by freeing up the opportunity for more debt?
A crisis has most likely been averted. The market will still remain on tenterhooks for some time, but it has faith in the Fed to do what is needed. Now it’s up to the banks and the American consumer. The US economy represents 25% of global GDP. US consumer spending represents 70% of US GDP.
