Fed and the Usual Suspects by Leeanne Su
Speculation of an interest rate cut at the Federal Open Market Committee’s November 6th meeting escalated to a fevered pitch last week after a series of economic reports pointed to a deceleration in the already uneven economic recovery in the U.S. While the data have not deteriorated to the degree qualifying for a double-dip recession, continued erosion could lead down this path. Considering that bonds are fully pricing in a 25 basis point cut, the debate has shifted to the magnitude of the rate reduction from the probability of an easing action. With market sentiment set on a rate cut, the Fed runs the risk of precipitating a sell-off in the dollar and equities if it decides against action, particularly if another split vote leads to concerns that the Fed is at a loss for the appropriate monetary medicine.
In an editorial last week, former Board of Governors member Wayne Angell argued in favor of a 50-basis point reduction in the Fed funds rate as a preemptive measure to avert deflationary pressure in the U.S. to avoid a replay of the woes afflicting the Japanese economy. Closely followed Fed watcher John Berry has thrown his weight behind a rate cut as well, speculating in his Washington Post column that a rate cut is imminent by year’s end, citing the possibility of war with Iraq, slowing economic recovery and the volatile stock markets as inciting factors for an easing move by the Fed.
Economic indicators released in the past two weeks have uniformly worsened. Talks of a rate cut initially reemerged when the September Fed Beige Book underlined the ongoing lethargy in retail sales and manufacturing activity. Moreover, a gloomy consumer confidence survey, followed by the weaker than expected third quarter GDP and a rise in the unemployment rate all added ammunition to the case for a rate cut. Third quarter GDP fell short of expectations with a 3.1% rise, an improvement over the 1.3% growth in the second quarter but still markedly slower than the brisk 5% in the first quarter. Many economists are expecting a pause in recovery in the fourth quarter in light of renewed economic weakness and the disruption caused by the West coast dock shutdowns. The employment situation appears stubbornly sluggish as well, as the October unemployment rate edged up to 5.7% and payrolls fell by 5,000, which could have negative repercussions on consumer sentiments. While the resilient housing market has helped cushion the blow thus far, consumer spending will stay depressed if economic recovery and the labor market continue to stall. And even though equities have rebounded from their early October multiyear lows, the recovery has mainly rested on a wobbly foundation of earnings reports that met expectations only after being previously revised downward.
The Options
Another sign that the FOMC could be headed towards a rate cut is the split 10 to 2 vote at its September 24th meeting, where Fed Governor Edward Gramlich and Dallas Federal Reserve President Robert McTeer voted to trim interest rates. Given the recent economic setbacks, the two dissenting members will certainly be inclined to hold their position. They might also gain few more adherents to their camp in the Committee.
While a 50-basis point reduction would deliver a more potent dosage than a mere 25-basis point cut, a smaller rate cut presents the more feasible scenario. Since opinion among the FOMC members could remain mixed, it would be easier to convince the anti-easing camp into voting for a cut of a smaller magnitude, making this compromise the more effective option for any easing.
The other possible outcome -- maintaining an accommodative bias while keeping rates unchanged at 1.75% -- could bode poorly for US stocks by undermining confidence in the Fed’s capability to support the flagging economy. This is especially the case as the 2-day equity rally was largely based on hopes of a Fed easing.
Will a rate cut provide an effective spark for the economy? Businesses have been slow to re-ignite spending and investment, and with rates at already at 40-year low, a rate cut won't necessarily offer enough incentive unless it can also boost sentiments. And as for consumers, the driving force of the U.S. economy, there is only so much benefit lower interest rates can bring to the table.
Nevertheless, if the Fed does not act, market disappointment could trigger another round of dollar dumping. The Fed's invincible aura during the late 1990s has been tainted by hindsight accusations of benevolent neglect throughout the equity bubble, and a failure to act decisively could deal another blow if markets perceive it as a complacent extension of the Fed’s laissez-faire attitude.
Cutting Without a Wim?
Last week, traders stampeded to dump the greenback when U.S. fundamentals disappointed market expectations, despite the fact that economic conditions in the Eurozone and Japan still remain arguably more dismal. The IMF revised down its 2002 forecast growth for the Eurozone to a measly 0.75%, much below U.S. growth forecasts. In spite of the comparatively anemic growth in the Eurozone, the euro flirted with parity Friday on dollar-negative economic news. Likewise, the yen climbed to a one-month high against the dollar even amid a watered down anti-deflation and banking package that many have deemed insufficient to remedy the ailing Japanese economy.
Meanwhile, the dollar and the stock market diverged; whereas stocks marched to a positive finish for the fourth consecutive week, the greenback was subjected to broad selling pressure, indicating that fundamentals have recaptured center stage following the end of the earnings announcement season.
An interest rat cut by the Fed could also spur the Bank of England into action and nudge the European Central Bank into softening its stance at their respective meetings on Thursday. Minutes from the Bank of England’s Monetary Policy Committee’s last meeting showed a split 6 to 3 vote in favor of keeping rates steady at 4%, which means the tide could easily turn at its upcoming meeting. If the BoE does not follow suit, it runs the risk of fueling renewed appreciation in the sterling, with the effect of tightening the monetary noose on its stalling economy. Further, the bank would be hard pressed to explain the rationale behind a much higher interest rate differential between the U.K. and the U.S. even though the 0.7% rise in third quarter GDP in the U.K. under performed the 3.1% growth in the U.S.
In the case of the ECB, one should delineate the distinction between what the ECB ought to do and what it is likely to do. Economists and national officials have repeated said the ECB ought to ease interest rates, but the obstinate and inflation-wary central bank has been quick to defend its inflation target and assert independence from external pressure. Yet by doing so, the ECB has maneuvered itself between a rock and a hard place. An ensuing cut by the ECB would place the central bank in an inconsistent light, but a failure to act will be seen as intransigence.
Nonetheless, currency markets signaled today that the euro prefers an easing with some consistency, rather than consistency and no cut at all. Such signal took place when Bundesbank Chief and ECB council member Ernst Welteke said the Bank was listening to demands urging it to cut interest rates. German bunds did rally on the comments and so did the euro on hopes that the 18-men and women in Frankfurt may finally trim rates. On the other hand, if the ECB remains recalcitrant, it could provoke a negative reaction in the single currency and risk a break below EUR/USD’s $0.96-0.99 consolidation pattern of the past few months.
This week’s central bank parade promises to be a must-see show. Due to the high probability of a rate cut by the Bank of England, and a smaller chance of such a move by the ECB on Thursday, the Fed’s expected 25-bp cut decision will likely trigger a contained reaction in currency markets on Wednesday, as traders await the course of action from the other side of the Atlantic. A concerted easing among the Fed, the BoE and ECB will mark the first joint rate cut since exactly a year ago and serve up the best remedy for the global malaise. As the least predictable participant, the ECB has the most potential to stir currency markets with its decision.
-Nov. 5, 2002
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