Thursday, August 30, 2007

The Federal Reserve Policy - from here

That the Fed will cut on Sep 18 is a certainity - Fed doesn't like surprising markets. The question is - will Fed cut down all the way to 4.50 by the end of the year?

The Fed wants to balance growth and inflation. Growth is equivalent to reduction in unemployment.

Right now, the trouble in the real economy is in the housing market. Still, unemployment rate has remained low at 4.6%. At its August meeting, the Fed cut its outlook for growth for 2H by 25bps, without changing its inflation outlook, because of lower productivity gains (I predicted this correctly What this implies is that if Fed cuts too much and ends up stimulating the economy, growth could be above trend and lead to unemployment rate remaining where it is (or decline). This could worsen inflation over time. Recall that after Sep 1998, Fed cut by 75 bps, and that was enough to start the tech bubble.

Has what happened last month increased the chances of higher unemployment going forward? That is the only reason Fed should cut substantially. I don't know the answer to that. Unless Fed is convinced that unemployment rate is headed to 5%, they shouldn't cut substantially.

What is happening in US is interesting. Is it possible that strong exports to a strong world economy offset weak domestic growth in US? Then you might continue to have strong employment.

Another issue is this - the current problem is in the asset backed commercial paper market, where investors don't trust assets underlying some of the conduits. Even if Fed cuts rates, these mortgage backed assets are not regaining investors confidence anytime soon, because of the suspect credibility of their ratings. It is very likely that more rating downgrades by S&P, Moodys are on the way - $120bn of subprime ARMs are being reset this qtr and next. So some other AAA CDOs are going to 0. Investors are already looking at the scenario and refusing to rollover the CP backing these securities. So the Fed could cut rates by 25 bps, and CP market could continue facing issues.

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