The Fed: Easing Up on Easing?
Will the Federal Reserve add one last quarter-point rate cut on Apr. 30 to cap its current policy cycle—which has seen 300 basis points in cuts—and then hit the "pause" button? Here's a roundup of what some Wall Street economists, strategists, and academics expect from Bernanke & Co., as compiled by BusinessWeek and Standard & Poor's MarketScope staff.
We are forecasting a quarter-point cut in the Fed funds rate target by the Federal Open Market Committee (FOMC) at its Apr. 29-30 policy meeting, to 2.0%—a view widely shared by the rest of the market. In fact, some now question whether the Fed will ease at all, vs. the debate over whether the central bank would cut rates by 50 or 75 basis points that swirled in financial markets earlier this month.
Here's what has happened to dampen Fed easing expectations: Commodity prices have failed to moderate, as per the Fed's forecast, and have instead surged. This has prompted a meteoric 40-basis-point rise in the yield on the 10-year note over the past two weeks, to 3.85%. Food and energy prices have soared, while the dollar has weakened further. The economy outside the housing sector is not as weak as economists had feared. Add to those factors a $168 billion fiscal stimulus plan, 300 basis points of rate cuts already in the system, and indications that more rate cuts may not be the answer to financial market ills, and it's no wonder that recent speeches from Fed officials have indicated more caution on monetary policy easings.
Minsky, McCulley, El-Erian, Gross, Feldstein, Summers, and a host of others would likely argue that additional policy measures are required to support home prices, which have fallen by 10% over the past 12 months and are set for a repeat by this time in 2009. Lower Fed Funds? They would, in PIMCO's opinion, likely do more damage than good from this point forward. Foreign and domestic investors are being fleeced with negative real interest rates, and the weak dollar, stratospheric commodity prices, and steadily rising import inflation are the result. The better alternative is to initiate a limited mark-to-market writedown of private mortgage debt as envisioned in the Dodd-Frank congressional proposal, combined with government-subsidized loans at below-market rates.
David Joy, chief market strategist, RiverSource Investments
For the past several weeks, investors have been focused on first-quarter earnings, particularly those of the major banking institutions, while looking for signs that the economy is set to improve.
Few are suggesting that the credit crisis has run its course, but the movement in an array of asset prices indicates that sentiment has been turning more positive. Bond yields have risen, particularly at the short end of the curve, along with stock and commodity prices, even as the dollar has firmed.
This week, the focus will be fixed intently upon the Federal Reserve and the economy. With the two-year-note yield now well above the fed funds rate, expectations of further aggressive easing by the Fed have been scaled back. Two weeks ago, futures trading indicated an almost even chance of a half-point rate cut. Now, there is less than universal agreement that the Fed will cut at all.
And where there was the expectation that the overnight rate would be cut to a low of 1.5% by August, the expected terminal rate for this cycle is now 2%.
Peter Morici, professor, University of Maryland School of Business
The Federal Reserve will almost certainly cut the target federal funds rate a quarter-point to 2% on Wednesday. Fed watchers will be looking at the policy statement for clues as to whether the Fed will pause after cutting rates 3.25 percentage points since June.
The Fed may like to stop cutting rates. So far, rate cuts have aided homeowners with adjustable-rate mortgages and other borrowers with loans indexed to domestic interest rates. However, those cuts have not substantially increased bank lending.
Simply, no matter the prevailing interest-rate environment, banks are frozen out of the bond market, where they have increasingly raised funds, over the last two decades, by bundling loans into securities. Having been sold loan-backed securities that were more risky and worth less than the banks represented during the subprime boom, the insurance companies, pension funds, and other fixed-income investors don't trust the banks.
Despite changes in the leadership at some major financial houses, banks have done little to win back trust. Similarly, the bond-rating agencies seem wedded to cozy relationships with banks, accepting payments from banks to rate securities the banks create.
The trade deficit—in particular, the rising oil import bill and stubborn deficit with China on consumer goods—is a drag on domestic demand equal to 5% of gross domestic product. The falling dollar against the euro and other market-determined currencies has helped. However, oil is priced in dollars, and the dollar continues 40%, or more, overvalued against the yuan and several other Asian currencies.
Until Bernanke addresses structural problems in bank participation in securities markets—something Treasury and Group of Seven proposals for financial market reform do little to address—adequate bank credit to power an economic recovery will not be forthcoming, and unemployment will rise.
We expect the Federal Reserve to cut rates again at its meeting Tuesday and Wednesday, probably by 25 basis points, to 2.0%. There is still a chance of a 50-basis-point cut, but probably only if the first-quarter GDP growth comes in strongly negative. Because of the higher-than-expected inventory accumulation, it now appears that first-quarter growth will be significantly positive, probably close to 0.5%. But because the extra growth is mostly inventory, the second-quarter estimate is likely to be more negative than our last forecast, although we will wait for next Friday's employment report to change our forecast.