Fed Easing Not a Slam Dunk

Bernanke & Co. will still wait for evidence the credit crisis is affecting the broader economy before moving on a full-fledged rate cut

With the Aug. 17 move by the Federal Reserve to lower its discount rate 50 basis points—and its in which the central bank boosted its assessment of downside risks to the economy—policymakers have opened the door for the Fed to alter its policy stance.

The Fed is likely to at least shift its inflation-fighting slant to a neutral bias, in which it sees risks to the economy evenly balanced between rising inflation and slower growth, and may chose to adopt an outright bias toward slower growth. And the Fed could lower the policy target rate. But any aggressive future move is hardly baked in the cake with today's statement, despite the wishful thinking of some observers.

Much, of course, will depend on data between now and the Sept. 18 meeting of its rate-setting arm, the Federal Open Market Committee (FOMC). Indeed, the fact that the Fed avoided referencing a new bias statement in the Aug. 17 release reflects that FOMC members are still unclear as to what the change in the bias will be at the next meeting, let alone the target Fed funds rate, which remained unchanged at 5.25%.

Analyzing the Fed's Statement

The Fed no doubt wants to keep all its options open between now and then—unless a specific insolvency emerges that implies systemic risk to the banking system and an associated immediate policy response. This is a key point for market players who assume that the Aug. 17 Fed statement is a signal that a policy-easing, in the form of a cut to the Fed funds target rate from its current 5.25%, is set for September.

Though the risk of Fed easing remains high as long as the liquidity crisis continues to plague the global financial markets, we will assume no policy change at ensuing Fed meetings until we see an impact on reported economic data that would likely alter the Fed's estimates for growth. Of course, heightened financial volatility suggests that downside risks to the economy have increased. If the macroeconomic data between now and Sept. 18 track the Fed's existing in-house projections—and there is a good chance that the figures will—then at least some FOMC members, and maybe all, will be reluctant to change the path of policy.

To be sure, a sudden financial market dislocation in the interim, especially if it threatens the banking system, could easily prompt an interim Fed easing. But until we see the current non-bank financial problems threaten bank performance overall, our assumption will be: no policy change.

Parallels to 1998 Fed Easing?

While parallels to the current situation are often drawn to the 1998 Fed easing after the long-term capital management hedge-fund blowup, the associated global financial crisis actually began in mid-1997. The Fed withstood market pressure to ease policy for more than a year, despite widespread belief on Wall Street that the Fed was not correct in its evaluation of the balance of economic and inflation risks.

It took a specific domestic financial crisis that threatened the U.S. banking system for the Fed to act, and that easing was, predictably, followed by a period of heightened economic and inflation growth that grew problematic for the Fed through 1999 and 2000. Though the easing of policy in 1998 may have been a necessary step at the time by then-Chairman Alan Greenspan, this policy-easing proved counterproductive for Fed efforts to steer the economy and inflation, as the Fed itself had suspected through the prior year.

It's our guess that Fed Chairman Ben Bernanke shares this interpretation of that period and would prefer to avoid that outcome. As such, we think that Bernanke will be resistant to addressing market liquidity concerns with an outright policy-easing until he legitimately perceives significantly greater economic risk, or believes that inflation pressures are subsiding. Short of that, as with his predecessor Greenspan, it will take a specific insolvency event that requires the Fed's immediate intervention to mitigate systemic risk to the banking system. And such an event, though a distinct risk in the weeks ahead, will be impossible for the markets to predict in advance.

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