Saturday, September 15, 2007

On Tuesday the Fed will...

On Tuesday the Fed FOMC will...

Exactly. What will the Fed do?

[Spoiler: The Fed will leave the Fed funds target rate unchanged.]

Despite the virtual unanimity of Wall Street "professionals", economists, commentators, the media, et al, that a Fed rate cut of either a quarter or half point is a "slam dunk", there actually is no evidence that a cut is a true slam dunk. It is a slam dunk in the sense that WMDs were a slam dunk before we went into Iraq: everybody believed that it was true, but nobody had any substantial, robust hard evidence to back up their belief.

To be sure, recent Fed speeches have clearly indicated that the door is open and that the Fed will do whatever it has to do to protect the real economy from the effects of turmoil on the financial markets, and several Fed officials seem to be leaning in the direction of a cut, but that still does not amount to a true slam dunk case for a rate cut.

Yes, the economy is somewhat weaker, but not to the degree that a recession is imminent.

People like to draw parallels to past crises, notably 1998, and suggest that the Fed will stay true to form and cut rates aggressively, but this ignores the simple fact that people in and near the Fed widely view that Fed action in 1998 as overly-aggressive and having led to the boom and bust in 1999 and 2000. Yes, by all means draw attention to parallels with 1998, but this time could well be a historic "do-over" where the Fed decides to not make the mistake that they feel they made in 1998 and holds back from cutting rates aggressively. That is not to say that the Fed might not give the markets a symbolic cut, but does argue strongly against a series of aggressive rate cuts being a slam dunk.

The recent Fed speeches were all over the map, with comments ranging from a worry of significant more downside due to housing and mortgage issues, to an insistence that it is not the job of the Fed to bail out investors (on Wall Street) who made very bad investment decisions. The number of speeches and the range of speeches appears to have been intended to assure everybody that the Fed is alert to deeply looking at all aspects of the problem and won't make up its collective mind until the committee actually meets on Tuesday.

My own reading is that the Fed is mindful of the fragility of public confidence (even for tough Wall Street bankers and traders) and is bending over backwards to speak as if comforting rate cuts were on the way, all the while they are simply stringing people along even though they privately know how they would want to vote if the FOMC meeting were held today.

As far as I can tell, the Fed is still quite concerned about inflationary pressures and would be very loathe to undo all of their progress over the past couple of years simply to "give the financial markets what they want." As one Fed official said last Monday, setting monetary policy is not (should not be) a popularity contest.

One piece of the puzzle that we in the public, on Wall Street, and in the media do not have access to at this point are the private discussions that Fed officials are having with business leaders in the final week leading up to the FOMC meeting. This informal "data" will be the most timeliest with regards to the economic outlook for the coming months and could well be the deciding factor as to any change in monetary policy on Tuesday. If a majority of the voting members of the FOMC are hearing in private from a majority of business leaders that the economy is in big trouble and that these business leaders are in the process of pulling back on spending, then a rate cut will become a true slam dunk. But if the general sense is that there will be some weakness but the economy will pull through anyway then maintaining the fed funds target rate steady albeit with "heightened vigilance" will become the slam dunk.

I am a pragmatist and my goal here is not to lobby for what I want or figure out what the Fed "should" do or what Wall Street wants, but to judge as best I can what the Fed is likely to do.

After having considered all of the information available to me, today and over the past nine years, I have to say that: 1) yes, the Fed might cut rates on Tuesday, but 2) the Fed is more likely to hold its fire and keep rates paused while it engages in "heightened vigilance".

I would say that there is really only a 40% chance that the Fed will cut rates at all, and maybe only a 25% chance that the Fed will cut the fed funds target rate by a half-point.

I would say that there is still a 75% chance that the Fed will remain paused. And even then they will likely continue to use language that suggests that a cut is imminent if they sense that the economy is about to fall apart.

In short, my call is that there is a 40% to 75% chance that the Fed will leave the fed funds target rate unchanged on Tuesday and that most likely the Fed will in fact leave the fed funds target rate unchanged on Tuesday.

I also continue to believe that despite ongoing weakness in the housing sector, there is enough deep strength in the rest of the economy to keep the overall economy cruising along at an annualized real GDP growth rate in the 2.00% to 3.25% range over the next twelve months, albeit with a significant level of volatility. There will not be a recession, nor will there be two consecutive quarters averaging less than 2.25% annualized real GDP growth.

Hence, it is also my call that the Fed will leave the fed funds target rate unchanged for the remainder of the year and likely all of next year.

-- Jack Krupansky

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