Fed Candy

Someone over at the Fed has a strange sense of humor. The “second most important FOMC meeting of the year” is due to convene today, which as we all know is Halloween. Before you get too spooked by the occasion, remember that the Fed has already blinked by cutting short-term rates one-half a point to 4.75% when the central bank last convened in September.

It is expected that there will be a quarter-point rate-cut (today, this will be known as “Fed Candy”), taking the fed funds rate to 4.5%. But the Fed is going through a very delicate balancing act between providing enough liquidity to keep the big US economic engine running smoothly, but not too much so as to create inflation. And of course any action or inaction will be poured over by investors, who seek guidance about the future of the economy and the Fed’s intentions. I keep thinking about the situation as a tug of war between rotten housing/looming mortgage resets on one side and the forces of inflation on the other.

The recent data on housing indicates that sales of new and existing homes will likely soften as tighter lending standards depress demand and choke off activity. But thus far, the impact of housing on the broader economy has been somewhat muted. Similarly, despite signs of healing in the credit markets (commercial paper spreads have narrowed, and 3-month Libor has dipped below 5%), the news out of the nation’s large investment banks continues to beg the question whether we truly know the actual losses incurred.

I am guessing that we’ll see a ¼ point cut simply because the market seems to be forcing the Fed’s hand, and policymakers are offering little resistance. Although the Fed does not want to be seen as cutting too fast and fostering a moral hazard (it’s OK to invest significant sums into risky assets because if the trade goes bad, you count on the central bank to bail you out), nor does the Fed want to be seen as fanning the inflation flames, especially as the US dollar is making new lows, but the fear of recession seems to be more dominant, so get your bag ready for the candy! (They can counter the inflation concerns by citing weaker US growth and specifically housing, which should increase economic slack and thus compress pricing power. Low core inflation should give the Fed latitude to ease monetary policy further.

In the end, it will be important for the Fed to articulate the case for cutting in the accompanying statement. Most expect that the language will be similar to September’s, stressing the uncertain economic outlook and a desire to forestall the potential spillover effects associated with the ongoing correction in housing. Concurrently, the Fed will have to pay lip service to inflation, noting that “some inflation risks still remain”. In the end, the Fed will need to manage expectations by not saying either too much or too little. If you had to choose a Halloween costume for the Fed, I would suggest a mime, or if you have a sense of humor, there’s always Harpo Marx. Enjoy your Fed candy—it sure tastes sweet, especially when reviewing your investment statements.