The End of the Line for Greenspan & Co.?

Could the current string of rate cuts be nearing an end? The markets are beginning to think so

By Michael Englund

Most investors probably view the expression "the end is near" as more apropos for the technology sector than the recent string of Fed easings. And yet market prices are telling us that the Fed is quickly nearing a "wait-and-see" approach for the Fed funds rate.

The May 15 meeting of Fed policymakers provides the central bank three vehicles to signal a near-term end to the easings. One would be to downsize the pace of easing to 25 basis point increments. Another would be to adopt a "neutral" bias. A third would be a subtle hint in the wording of the policy announcement. S&P's view concurs with most Fed watchers that we will see both a 50 basis point rate cut to 4.0% and a continued easing bias -- but with these three downside risks.


  These risks have produced a disconnect between the stated position of Fed watchers and the prices prevailing in the Fed funds futures market, with the Fed watchers revealing a more dovish outlook for policy. In an S&P survey conducted May 11, all but one of the seventeen Fed watchers contacted expect a 50 basis point easing at the May 15 meeting, with the remaining holdout looking for 25 basis point easings at each of the next two meetings.

Views over the next two FOMC meetings are dispersed, but forecasts for the funds rate level after the August meeting are more or less equally divided between projections of 3.50%, 3.75%, and 4.0%.

The story from the Fed funds futures market is more bearish. Here, the market seems to have discounted a 4.05% funds rate in the remaining days of May, which translates to likelihoods of 80% for a 50 basis point easing at today's meeting and 20% for a smaller 25 basis point easing. Beyond today's meeting, futures contracts have centered on a 3.90% funds rate floor around July, which would imply only a 40% likelihood of another 25 basis point easing if the Fed moves 50 basis points today. This is 15 basis points more bearish than the median from our surveys.


  Even this more bearish outlook, however, implies that the Fed should both ease by 50 basis points on May 15 and maintain the bias statement that "the risks are weighed mainly toward conditions that may generate economic weakness in the foreseeable future."

As such, any signal to the market would need to be seen in the wording of the announcement, where the Fed could: 1) refer to the growing need for the Fed to assess the impact of recent policy changes on the course of the economy; 2) state that the inventory adjustment process appears to be approaching its end; 3) point to ongoing strength in some sectors of the economy, such as consumption and construction; or 4) cite concerns about inflation.

Recent data have provided justification for these potential disclaimers to the magnitude of the asymmetric risks. Substantial downward revisions in the inventory figures for Q1 suggest a sizable impact on the reported GDP figures that will leave little room for further inventory deterioration in Q2 and Q3. And last week's retail sales and consumer sentiment figures raised the risks that weakness in inventories and the tech sector will fail to transfer to the broader economy.

Finally, inflation concerns should remain in place at the Fed despite the market's focus on the tech sector and the stock market, as was recently highlighted in the producer price index (PPI) report for April. At some point, the Fed should rightly pause in its easing trajectory and assess the cumulative impact that past easings are having on the economy.

Englund is Chief Market Economist for Standard & Poor's

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