What will the Fed do?

It was quite amazing and amusing to see the reactions to Federal Reserve Chairman Bernanke's speech on Thursday. Sure, he allowed that the Fed could and is willing to act aggressively, but somehow that got stretched into a slam dunk certainty that the Fed will act, which is not what Bernanke said at all. In truth there will be more than enough new economic data, including the latest Fed Beige Book, plus candid, private discussions between FOMC participants and banking and business leaders in the days immediately before the FOMC meeting, so that there will be plenty of room for the Fed to evolve to a significantly different position than what people seemed to be misguidedly assuming after they distorted Bernanke's speech.

OTOH, enough people were already talking about a half-point cut as being a done deal before Bernanke's speech, as well as being indicated by fed funds futures prices, that this was Bernanke's opportunity to disavow that presumption and he most certainly did not.

Fed funds futures prices are usually a fairly reliable indicator within 45 days of an FOMC meeting. As of the close on Friday, February fed funds futures were indicating a 100% chance of a half-point cut plus a 40% chance of an additional quarter-point cut. Part of this betting is that some people believe that the Fed may be forced to cut before the FOMC meeting as well as at the meeting.

The economic data of late has been mixed enough that there is no need for the Fed to cut its target rate before the scheduled FOMC meeting. I do believe that a quarter-point cut is a slam-dunk and that a half-point is a distinct possibility if we see significant deterioration over the next two weeks. The weekly data, such as chain store sales, unemployment claims, mortgage applications, and commercial paper issuance, will give the Fed some hard data to consider. As important, a wide variety of banking and business leaders will privately tell Fed officials what they really think is needed.

Please note that changes to the fed funds target rate impact the real economy with a significant lag, on the order of months to a year or more, so it would be incorrect to presume that any recent economic weakness was an indication that Fed monetary policy was not working. Actually, mortgage applications were up sharply last week, so there is at least some evidence that there has been some positive effect to date.

-- Jack Krupansky