Originally Posted by ABN AMRO - Tim Drayson
Economic comment
Entrapment
Tim Drayson
As was widely expected, the Fed delivered a 25bp cut in its funds and discount rate. But
Thomas Hoenig dissented, preferring no change. This indicates the decision was more finely
balanced than market pricing would suggest. After opting for a surprisingly large 50bp cut at
the last FOMC, the evidence to justify a further loosening was far from overwhelming. We'll
have to wait for the minutes, but I doubt the staff has made any downward revisions to their
2008 growth forecasts since the September meeting. In taking the decision, the FOMC
probably paid less attention to the robust 3Q07 GDP figure, and instead focussed on the
higher frequency data. There has been some softening, but no more than the Fed
anticipated. So I think the Fed was reluctant to ease, but felt compelled to because failure to
act might have unsettled markets. After all, the risk management approach is designed to
stabilize financial markets and prevent the adverse effects on the broader economy from
developing.
The statement required plenty of redrafting. The Fed noted that 'economic growth was solid
in the third quarter, and strains in financial markets have eased somewhat', but
acknowledged that 'the pace of economic expansion will likely slow in the near term, partly
reflecting the intensification of the housing correction'. The language on inflation was
expanded to include more explicit guidance about the risks, 'recent increases in energy and
commodity prices, among other factors, may put renewed upward pressure on inflation'.
Most important, and in a bid to damp speculation of further substantial cuts, the Fed inserted
an assessment of the balance of risks, saying 'the upside risks to inflation roughly balance
the downside risks to growth'. The statement concluded with the same line about acting 'as
needed'.
The fed funds rate is now around neutral and with government bond yields and the majority
of credit spreads still low and the dollar weakening, monetary conditions are not restrictive.
The economy is close to full capacity, global growth remains robust and commodity prices,
most worryingly crude oil, are soaring. As medium-term inflation risks are increasing, I don't
think the Fed sees the need to loosen policy further. But with markets pricing in further rate
cuts, the Fed has a communications issue. The statement is the first attempt to outline the
Fed's thoughts, but in subsequent speeches and the minutes I expect the Fed to explain that
because it has frontloaded rate cuts, it doesn't need to cut rates again if the data softens as
it's expecting. It's conceivable that market turbulence could re-intensify and we get more
evidence of broad-based economic weakness. A sustained drop in the monthly ISMs or rise
in unemployment could force the Fed to loosen even further. But because the Fed has been
remarkably pre-emptive, the most likely scenario is sluggish growth near-term before
returning to potential in the second half of 2008. At this stage the Fed has limited ability to
prevent the housing correction running its course, but it can help promote macro stability by
ensuring that inflation and inflation expectations remain well contained. As a result, I expect
the Fed to remain on hold through 2008.