After the stock market's late-July rout, plenty of pundits assume the cavalry will come to the rescue. They say it's a near certainty that the Federal Reserve will cut interest rates to keep credit conditions easy and the economy growing.
But will the Fed cut? Don't be so sure.
Federal Reserve Chairman Ben Bernanke and his fellow rate-setters have been saying all along that they regard inflation as a greater threat than slow growth. And the real economy—as opposed to the financial markets—remains reasonably healthy. The Commerce Dept. reported July 27 that the gross domestic product grew at a brisk annual rate of 3.4% in the second quarter. So, unless the market downturn snowballs, a 2007 rate cut remains not much more than a 50-50 likelihood. There's even a chance that the Fed's next move will be to raise, not cut, interest rates.
Playing It Safe
It's easy to understand how people got the idea that the Fed is going to open the money spigot. Spooked in part by worse-than-expected news on housing sales, the Dow Jones industrial average closed at 13,406 on July 27, a decline of 600 points from its all-time high—a shade over 14,000—just eight days earlier. Stocks from ExxonMobil (XOM) and Bristol-Myers Squibb (BMY) to Net player Akamai Technologies (AKAM) and homebuilder WCI Communities (WCI) have taken it on the chin (see BusinessWeek.com, 7/27/07, "Uncertainty Reigns on Wall Street").
Fixed-income investors lost a lot of their appetite for risk: Investors abandoned junk bonds and other high-yield securities for the safety of U.S. Treasury bills, notes, and bonds. Investment bankers were left holding $20 billion from two leveraged buyouts in motion, the deals for the Chrysler unit of DaimlerChrysler (DCX) and for the British pharmacy chain Alliance Boots. Fear seemed to overtake greed as the primary emotion on Wall Street.
But remember, it's not the Fed's job to bail out stock and bond investors. The Fed takes notice of the financial markets only when conditions there threaten to cause a genuine credit crunch—that is, when even credit-worthy companies and families can't borrow money. We're still far from that scenario. In the mortgage market, for example, prime borrowers are getting, if anything, even more offers of credit because lenders need to make up for their lost subprime business.
Not a Sure Thing
Where did the idea arise that the Fed was certain to cut? Partly from the federal funds futures market, in which speculators bet on the likely level of the federal funds rate. That's the rate on overnight loans between banks that the Fed controls by adding and subtracting reserves in the banking system. It's currently at 5.25%. The implied rate for the December futures contract fell to just over 5%, leading some analysts to proclaim that the markets saw a "100%" chance of a Fed cut by the end of the year.
But markets never see a 100% chance of anything. Traders recognize that there's no such thing as a sure bet. The just-over-5% figure represents the weighted average of bets by people who predict the rate will be anywhere from 5.5% to 4.5%, or beyond, by December. A more sophisticated way to analyze the market is through options analysis. According to Bloomberg Financial Markets' options analysis of the fed funds market, as of July 26, the markets were seeing a 43% chance of no change in the rate by December, a 20% chance of a cut to 5%, a 28% chance of a cut to 4.75%, and a 5% chance of a cut to 4.5%.
And yes, the funds rate might even rise. Dean Maki, chief U.S. economist of Barclays (BCS), expects gasoline price inflation to subside and consumer spending to rebound, allowing the economy to grow at a rate of 3.25% in the second half, which would be so strong that it would cause the job market to tighten and push wages up. Says Maki: "We expect the next move from the Fed will be a hike, and we do expect that later this year."
A Long, Calm View
Of course, only a small minority of economists see the Fed hiking rates. But even as the market's turmoil made the headlines and the evening news, lots of economists take a longer, calmer view than traders do. Brian Bethune, chief U.S. economist of Global Insight, says, "The market does tend to oscillate.… At this point the Fed's on hold." The Fed won't even think about cutting rates until it sees the inflation rate "consistently within its comfort zone," Bethune says. He thinks that won't happen until early 2008.
The 600-point fall in the Dow industrials may look enormous, but it amounts to only a little more than 4% of the Dow's value. "I don't think that's a sufficient condition for the Fed to react," says Jeoffrey Hall, chief U.S. economist of Thomson Financial (TOC). Hall does expect a Fed rate cut, but probably not until the fourth quarter, which is the same prediction he had before stocks tumbled.
Even economists who do think the Fed will cut rates substantially this year downplay the effect of the stock market on its decision. UBS (UBS) economist James O'Sullivan expects the Fed to cut the federal funds rate by half a percent by the end of 2007, to 4.75%. Not because of the Dow's troubles, though. UBS sees the economy's growth rate slowing to 1.7% in the third and fourth quarters, largely because of the steep downturn in the housing market. "The probabilities are always shifting a little bit. The drop in the markets just increased our confidence in the call for easing," says O'Sullivan.
Yes, stocks took a beating. But don't count on Ben Bernanke to save investors from a bloody nose.