Fed Meeting: Rate Cut Likely, Then What?
If David Bowie were disposed to write about the aeronautical adventures of someone other than Major Tom, perhaps "Helicopter Ben" Bernanke could fit the bill. Maybe he could call the new number "Rate Oddity."
With apologies to Mr. Bowie, the countdown is on for Federal Reserve Chairman Bernanke and the other members of the Federal Open Market Committee (FOMC), the Fed's policy-setting arm, as they seek to stabilize the financial system and insulate the economy from an even deeper and more protracted downturn into yearend. It's time to put our helmets on as the string of global data is unlikely to make the grade this week, with economic reports from the U.S. (housing starts), Japan (Tankan business survey), Germany (Ifo business sentiment), and the euro zone (purchasing managers' index) all set to accentuate that peculiar and unfamiliar economic feeling.
Policy meetings will also include the Bank of Japan, which is floating in limbo, and the Norges Bank, which is expected to cut base rates by a full percentage point.
But the main focus this week will be on the two-day FOMC gathering on Dec. 15-16, marking the last meeting of the abysmal and historic year of 2008. Note: The Fed has tacked an extra day onto Monday, Dec. 15, for "discussions" as it probes the "zero bound" and historically low target rate. The Fed is justified in deliberating carefully as it seeks to head off Japanese-style deflation, while at the same time cognizant of the policy trap of creating the next bubble.
Inclined Toward Stimulus
As the credit and financial crisis finally descended with a thud on the real economy this fall, and the collapse in energy and commodity prices sent inflation into remission, the Fed is likely to err on the side of economic stimulus. Little could "Helicopter Ben" imagine at the time of the last deflation scare that the Fed would one day be forced to shore up piece-by-piece the fractured financial system under his leadership.
Accordingly, at least a half-point reduction in the benchmark target rate to 0.50% is nearly universally expected. However, that rate has become largely irrelevant in the current quantitative-easing environment in which the Fed is paying interest on reserves, and the effective rate has been consistently tracking in the low 0.10% to 15% area. With only marginal downside room left for benchmark interest rates, traders will be anxious to see if the Fed elaborates on other potential tactics.
In this context, the Fed's communication strategy in the policy statement will take on greater importance than ever for its signaling effect. Chairman Bernanke has already stated the Fed will "do what it takes" to free up the disjointed financial markets. At a minimum, we suspect the Fed will intimate through its verbal guidance that the effective rate is likely to remain low and the economy weak for some time. This would be similar to the stance controversially adopted by his predecessor Alan Greenspan "for a considerable period" in semiannual testimony on July 15, 2003. Yet we would seriously advise the FOMC not to box itself in by suggesting a precise level or a time frame.
There has also been talk the Fed will issue its own Treasury bills or notes, though there is no legal authority for them to do so without a lengthy approval process by a skeptical Congress. That consent is unlikely to be forthcoming, given further risk of blurring the lines between monetary and fiscal policy after abdicating authority over the Troubled Assets Relief Program. More realistically, buying of longer-dated Treasuries remains a possibility and has already been broached by Bernanke, though he may hold that extreme option in reserve.
In the meantime, as the Fed considers expanding its already broad and growing portfolio of exceptional monetary actions and its $2 trillion balance sheet, other near-term options could be pursued. The FT.com reported on Dec. 12 that a variety of additional measures could include stepped up purchases of asset-backed securities, commercial paper, and potentially even longer-term corporate debt, which is not currently covered by FDIC guarantees past three years.
Purchases of municipal bonds might not be out of the question either, given budget strains in that sector and a financial crisis in California that's just the tip of the muni iceberg. A 4.5% 30-year fixed-rate mortgage by fiat, backed by Fannie Mae and Freddie Mac, could also be considered as a last-ditch solution.
We remain in uncharted territory, and policymakers may only decide to map out a broad strategy for unconventional intervention at this point, even as the incoming Obama Administration readies some historic infrastructure measures of its own for next year.
Ground control to Helicopter Ben, there's something wrong. Can you hear us, Helicopter Ben?