What will the Fed do?

Although the Federal Reserve has made it clear that they will be driven by incoming data, the data is in fact quite mixed (despite the views of some commentators.) Sure, some people are chattering that the "rising unemployment" in the latest employment report is an indicator that we are most likely falling into recession if not already there, the truth is that it simply is not so simple as that. It may have been so simple back in the days when we had a manufacturing-driven economy, but the U.S. economy has evolved dramatically since then. Most people acknowledge that the U.S. is now a service-driven economy, but somehow there are still quite a few people who are even to this day unable to accept that.

So, what will determine the Fed's actions at the upcoming FOMC meeting at the end of the month?

Although there will be incrementally more "hard" data, the primary determinant of the Fed actions will be the general tone of the feedback that they get when they have last minute conversations before the meeting with business execuives and their contacts at financial institutions around the country and in particular in the twelve regional Fed districts. Even last minute data reports give a lagged view of the economy, so the Fed governors and the Fed presidents are crucially dependent on on the up-to-the-minute, raw, unadulterated views that that receive in the final days before the FOMC meeting. Yes, the data matters too, but in an economy that is evolving rapidly and may or may not be on the "verge" of a recession, the Fed actually does do a good job of keeping a finger to the wind and an ear to the ground.

We will get the Fed Beige book soon, but even that will be somewhat dated compared to thos crucual last-minute conversations immediately before the FOMC meeting. Also note that the Beige book attempts to describe the current situation and does not attempt to look forward or recommend what Fed action may be required going forward. But, to be sure, if the economy is in recession, as some commentators insist, it would show up in the Beige book as a profound weakness across many sectors and regions of the economy.

The three critical economic reports from this past week paint a clearly "mixed" economic situation. The ISM Manufacturing report was clearly weak, the ISM Non-Manufacturing report was modestly strong, and the December employment report was mixed to weak. Nobody doubts that the Fed would be justified in cutting their target rate in the face of such data. The debate is over how aggressively the Fed should act.

A minimum of a quarter-point cut is a "slam dunk." Although quite a few people feel that a half-point cut is clearly requried, there is not widespread agreement on that point, especially with high energy prices, so a half-point cut is not a "slam dunk." Fed futures indicate a 66% chance of a half-point cut, which suggests that a half-point cut is almost but not quite likely.

My personal view is that the Fed will go ahead with another quarter-point cut for "insurance", but that the data simply doesn't warrant a more aggressive level of "accommodation." Despite the chatter of many commentaters, the overal real economy simply is not on the verge of falling of a cliff.

Also please keep in mind that there is an ongoing and necessary "adjustment" going on in the housing sector and the Fed need to avoid interfering with that adjustment and asset repricing process even as the Fed needs to strive to prevent that adjustment from infecting the rest of the economy. I know there is a lot of debate about all of that, but the simply truth is that the Fed is navigating that process about as competently as any government entity could possibly hope to do.

As a minor side note, this being a new year, the voting composition of the FOMC changes. Some Fed presidents will no longer have a vote and some who hadn't been voting in 2007 will begin voting in 2008. Note, that all twelve Fed presidents do participate equally in the FOMC meeting discussions, even if they do not get to vote.

-- Jack Krupansky