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Wednesday April 23, 2008 - 20:15:49 GMT
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Fed To Signal Pause in Easing

Next week the Fed meets to set policy and a quarter point rate cut is baked into the cake.  But there is some uncertainty over what the Fed will say in its statement.  Well there is less uncertainty than a week ago as the reversal in the curve steepener trade implies…the market is looking for the Fed to signal a pause in the easing cycle.  But the Fed will need to finesse the statement to avoid painting itself into a corner on rates as happened on two occasions in 2007 and to the detriment of the Fed. 


With 325bps of easing under its belt presumably next Wednesday at this time, the Fed will have put a considerable accommodative impulse into the economy making a pause more appropriate…it can argue convincingly it needs to sit back and observe the reaction (lagged reaction) to this enormous stimulus for a 7-month period   Cutting the Fed funds rate has also been largely neutralized by the credit crisis – from LIBOR to mortgage rates.  Simply cutting Fed funds does not necessarily yield broadly lower rates and a jump in borrowing and lending.  I suspect the Fed does not want to risk being perceived as pushing on a string (the liquidity trap) by continuing to cut rates. 


The Fed is also eager to check inflation expectations and the only way to accomplish this, apart from simply waiting for the economy to slow sufficiently to bring prices down, is to signal a possible lengthy pause in rates.   This will help stabilize the dollar (not sufficient condition to turn the dollar around) which is increasingly key to securing inflation expectations and the run up in commodity prices in particular.  Yes the dollar is in part driving the Fed to take a break on cutting Fed funds rate.


Like any activist central bank, the funds rate at 2.00% next Wednesday is at a level where getting to 1.00% or less does not take a lot of additional easing (already a negative real funds rate)…point is the Fed has to be wary of burning through Fed funds rate cuts before the recession has fully bloomed…keep some powder dry. 


Finally the Fed is not cutting the funds rate in a vacuum.  It has created a host of new mechanisms for adding liquidity to the bank and non-bank financial system.   These are accommodative measures in the first and final analysis, though it may take 12 months before banks are ready to take on risk again in any meaningful way.   


I think the politics of the crisis to date have largely been that the housing and subprime policy response mainly fell on the shoulders of the Fed.  I think the Fed is now saying we have done all we can and will do to get in front of the crisis and now it is up to the White House and Congress to confront the housing market crisis driving the subprime (credit) problem…some would argue that government, not the Fed, should have been in the lead on housing and not the Fed. 


Don’t get me wrong.  I still think Fed funds will be closer to 1% than 2% before the Fed is through – the recession is deeper and longer than the Fed believes and markets (now) are priced for.   However, we are in a very wide eye of the hurricane and it is time for the Fed to more deftly signal a pause in easing next week.  Look for the dollar to rally and commodities to weaken.  Nevertheless, I think this rally is corrective and we will see lower lows ahead as the other conditions for a turn in the dollar, ECB signaling two-way risk in interest rate policy and G7 joint currency intervention are still months off.


David Gilmore


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