The Fed's Balancing Act

Greenspan & Co. have convinced the markets that the economy could take another large rate cut -- without sparking inflation

By Michael Englund

A few weeks ago, it was looking like the Jan. 30-31 meeting of the Fed's policymaking arm, the FOMC, would prove critical for the markets. There seemed to be substantial risk that the Fed would either signal a heightened state of fear with a 50 basis point cut in the fed funds rate target, or a more cautious mindset with a 25 basis point move.

But the tension has since evaporated. The markets have concluded that the Fed will ease by 50 basis points, but without the associated panic. The Fed has successfully walked the razor's edge of convincing the market that the economy can use another sizable Fed easing without the troublesome inflation consequences that often emerge at the end of a business cycle.


  It is clear that the markets are expecting a 50 basis point easing in policy at the two-day meeting, despite conflicting "Fed sources" stories last week, and despite the split views seen by Fed watchers in the weeks before that.

The fed funds futures market is discounting a 5.51% funds rate average in February, which is one basis point short of pricing in a 50 basis point easing at this week's meeting with no inter-meeting February policy changes. And Treasury bill yields seem to be fully braced for a 50 basis point cut.

Fed watchers themselves are more cautious, with 32 out of 39 participants in our last survey, or 82%, expecting this week's funds rate cut to be of a 50 basis point size.


  The Q4 employment cost index (ECI) data released last week provided some important reassurance to the markets that the Fed had substantial leeway to ease. The ECI figures revealed a sharp slowdown in overall employment cost growth. This negated much of the upside risks to wage costs suggested December's employment data, which showed wages in the monthly employment figures through December rising sharply -- raising the risk that the Fed would face rising inflation pressures at just the wrong time.

As it stands, it appears likely that the monthly wage figures will slow sharply in Q1 to leave a less troublesome labor cost trajectory. But there is still an outside chance that the monthly wage figures will remain strong, and will translate to a hefty ECI rebound in Q1 that will ultimately tie the Fed's hands and exacerbate the slowdown.

The Q4 gross domestic product (GDP) data scheduled for release on the last day of the meeting should also allow the markets to readily accept another big funds rate cut from the Fed. We expect the GDP report to reveal a mix of component figures that will closely parallel those reported for Q3, with a 2.3% growth pace for both total GDP and final sales. These figures should reveal that the economy is slowing adequately to readily absorb another big Fed easing, but without signaling the sharp slowdown that some had feared. A sudden downturn in growth, just like higher wage inflation, would contribute substantial uncertainty to the near-term policy path.


  Some analysts have expressed heightened fears of a hard landing in recent weeks, and the Fed funds futures market is discounting a 5.00% Fed funds rate target by mid-year that implies an additional 50 basis points of funds rate cuts beyond the expected reduction this week.

But consensus forecasts from economists still leave GDP growth in the 3%-3.5% soft-landing trajectory by the second half of the year, which suggests that the Fed is expected to successfully stabilize growth. So the Fed is expected to move aggressively -- but without the perception of panic that followed the Jan. 3 surprise rate cut.

Englund is chief market economist for Standard & Poor's

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