Tuesday, August 07, 2007

Fed Meeting

It was exactly a year ago that Fed stopped raising rates. And perhaps this meeting is as crucial as that one for the outlook of markets over next few months. For, at both times, markets were pretty rocky just prior to the meeting.

Some people expect the Fed to change its language to signal risks of inflation and growth are now evenly balanced, vs inflation being a primary worry of the Fed till last meeting. After all, housing has been much worse than expected.

Question is: what level of growth is the Fed comfortable with? Recent revisions to historical data suggest productivity growth in last 3 years was slower than earlier reported. If productivity growth is lower, then the economy's growth potential is also lower. So while 2H growth outlook has come down following housing decline, this might now fit with the new reduced growth potential of economy.So the risks could still be towards inflation. But a few data points on productivity don't make a trend.

I am sure Fed will not move to neutral simply because of recent market volatility. While troubling, it is hardly a systemic threat. True some lenders and funds have blown up, but it is not the job of Fed to prevent every small $500 million blowup. True credit markets are seized up, but this is not LTCM with 6 sigma credit spreads. Credit spreads right now are more in line with historical averages. They are wider compared to where they should be because of low bankruptcy rate today.But they are not in unchartered territory.

A true test of whether risks are really dispersed enough globally would be to not intervene in the market and see how it plays out. One should also recall that Fed tightened in summer of 2000 when internet bubble burst, and didn't intervene till fall 2000. I vaguely recall Greenspan saying somewhere that we should let hypothetical bubbles build and if real, clean up the bubble after it has burst, rather than preventing a hypothetical bubble forming in the first place, as it might not be a bubble. If Fed signals it will be cutting rates, it would have let a bubble build and prevented it from a hypothetical bursting.For all the hue and cry of the last 2 weeks, Dow is off just 5% off its peak.

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