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Thursday, August 30, 2007

Is there going to be a rate cut?

This Friday night the Fed chairman Ben Bernanke is due to give a speech outlining his monetary policy in the wake of the housing & loan crisis. This speech, addressed to central bankers around the world, is intended to shape market expectations to its scheduled Fed policy meeting on Sept 18th 2007. According to Yahoo "analysts are predicting the Fed will start cutting the federal funds rate at that time, delivering from two to four quarter-point reductions this year and early next year. The funds rate has been at 5.25 percent for more than a year".
I frankly doubt the Fed is considering such an easy monetary policy. Certainly such cuts would reduce borrowing costs for consumers and businesses and mitigate the payment shock faced by 2 million mortgage holders as their adjustable rate mortgages reset in coming months. But since when does the Fed act as a welfare agency? Consider the Fed response to the collapse of the Thai baht in 1997 that was the beginning of the Asian financial crisis. It took the Fed more than a year to respond with a rate cut in Sept'98. Alot of investors suffered in the meantime. People might argue that this was an Asian crisis, but the reality is that the Fed policy is to preserve 'sustained growth' and to do that it needs to consider the inflation consequences of its policy.
Yahoo also suggests "The Fed is seen as having the leeway to cut interest rates because inflation is easing". But the implication that inflation is a 'product demand' phenomena is wrong - its a monetary demand phenomena. Excessive growth in money supply relative to the productive capacity spells inflation in at least some segments of the market. The reason food prices were not running away in recent years whilst money supply was increasing is because financial assets like shares and property were growing appreciably. Now asset prices are falling, that liquidity has to go somewhere. Well we are not going to eat more because of falling house prices. But there will be a slowdown in investment, so wasted financial resources means economic stagnation while prices increase.
It seems more likely to conclude that the Fed on Aug. 17 was merely calming financial markets when it said the "downside risks to growth have increased appreciably". Some market pundits seem to be interpreting this as justification for a rate cut - that the Fed is now more worried about weak growth than inflation.

Concluding, I dont expect a cut in the Fed Funds Rate on Sept 18th 2007. Tomorrow I suspect Ben Bernacke might even correct the perception somewhat. So I expect a weak market next week (1st week Sept'07).
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