A Break in the Action

Today the Federal Reserve convenes the Federal Open Market Committee (FOMC) meeting and we will find out whether the central bankers will cut interest rates for the seventh consecutive meeting. The current rate cut cycle started last September, when short-term rates stood at 5.25%. At that time, the FOMC noted that “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.” In retrospect, that may be one of the biggest understatements that the central bank ever made!

Seven meetings later, the fed funds rate is 2.25% and according to the futures markets, there is an 80% probability of a 25 basis points (1/4 point) cut to 2%. It is also likely that the accompanying statement will mention the possibility of a pause in the current rate cut campaign. The committee is likely to note that upside risks to inflation are now nearly as important as the downside risks to growth, a view voiced by various Fed officials recently. This has led Fed-watchers to reduce expectations from a 50 basis point cut to a 25-point cut.

Some believe that the cycle will end today, but I think that the Fed has to leave the door open for a variety of outcomes. There is still far too much risk in declaring the “all-clear” sign to investors. With food and energy prices soaring, a weak US dollar and rising inflation expectations, the Fed is grappling with two real and opposing forces: upside risks to inflation and concern about downside growth caused by the housing downturn and tight credit.

To balance these opposing forces, the Fed must be praying for the US economy to be weak enough to dampen inflation, forestalling any pass-through of price increases. Unfortunately, the Fed does not have any control over supply shocks, like those that continue to plague the crude oil market. Concurrently, the central bank does not want to see the country mired in a sluggish state for too long as threats from tight financial conditions, declining housing demand, falling home prices, and supply-induced spikes in energy prices, continue to lurk.

That’s why the opportunity to take a breath could not come at a better time---just as Uncle Sam is distributing $115 billion of stimulus checks, which is estimated to add 1% to Gross Domestic Product and as exports continue to add to growth. It seems that a break in the action is warranted this time around.