After policy U-turn, another Fed step anticipated

on August 17 2007 10:39 PM

Just 10 days after reiterating that inflation was its main concern, the U.S. Federal Reserve's policy-setting panel made a 180-degree turn on Friday, laying the groundwork for an interest rate cut as early as next month.

In cutting the discount rate charged on direct Fed loans to banks by one-half percentage point in a surprise early-morning move on Friday, the central bank stopped short of a full shift in monetary policy, holding its main interest rate steady.

But the central bank also signaled to panicked markets that it stood ready to act more aggressively, perhaps as early as its next policy meeting on September 18, when financial markets expect the main overnight federal funds rate to be cut.

In effect, (the Fed) is setting aside its inflation concerns and opening the door to a cut in the target federal funds rate to support growth, Global Insight economists Nigel Gault and Brian Bethune wrote in a note to clients.

Analysts said the move addressed the immediate problem that has been rattling global financial markets in the past week -- the free flow of cash. Concerns about who might hold dreaded subprime-related assets in their portfolios left many lenders suspicious and wary of handing over money.

Speculation was a favorite pastime for market watchers trying to divine the Fed's motivation, with a range of theories circulating. Part of the speculation was that the Federal Reserve might have been preparing to act in its role as a lender to a financial institution if one were in trouble. The Fed statement made no such reference.

The message to the financial community seems to be, it is safe to lend as normal, and the central bank will be standing close by, but the current situation does not rise to the level of a special rate cut outside of regularly scheduled meetings.

In an unusual between-meetings statement, the rate-setting Federal Open Market Committee said downside risks to growth have increased appreciably, and noted that tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward.

The word inflation appears nowhere in the statement.

50-50 CHANCE OF RECESSION

That was a sharp departure from the message from the Fed after the FOMC's last meeting on August 7, when policy-makers acknowledged tightening credit was hurting some households and businesses, but said the economy seemed likely to maintain its moderate pace of growth, supported by solid growth in employment and incomes and a robust global economy.

This, to me, is the functional equivalent of withdrawing the bias toward tightening and replacing it with a bias toward easing, said Lyle Gramley, a former Fed governor and senior economic adviser with the Stanford Group in Washington.

Gramley said the Fed's action would help restore confidence in markets overwrought by a sense of fear and panic that what began as a meltdown in the U.S. subprime mortgage sector was beginning to unravel credit markets.

He said the credit market turmoil had the potential to slow the U.S. economy, adding, I would say the odds of recession are now 50-50.

Judging from market reaction early on Friday, where stocks rose and safe-haven Treasury bonds gave back some of their recent gains, the Fed succeeded in pacifying rather than spooking anxious investors braced for the next financial disaster.

The Fed was stuck in the uncomfortable position of trying to prevent a credit crunch from derailing economic growth, while avoiding the appearance that it was riding to the rescue of investors who took extreme speculative risks on easy credit.

Some market participants were screaming -- literally, in the case of CNBC commentator and hedge fund manager Jim Cramer -- for a rate cut as global markets tumbled and banks, hedge funds and companies scrambled for suddenly scarce cash.

While the central bank likely bought itself the luxury of waiting until its next scheduled policy meeting to cut interest rates instead of a more dramatic mid-meeting move, critics pointed out that the Fed did nothing to address the underlying problem of easy credit leading to excess.

Markets should not be calmed by this tactic. Unlike the Fed funds rate -- which affects all banks' cost of funds -- a discount rate cut only lowers the cost of emergency borrowing by institutions in distress, High Frequency Economics wrote in a note to clients.

This move is not going to provide any relief to the overall economy. However, we believe that the Fed's action and statement today raise the odds of a reduction in the Fed funds rate at the September FOMC meeting, or perhaps even before.

Andrew Busch, global foreign-exchange strategist with BMO Capital Markets in Chicago, agreed that the Fed's action will not solve the bigger issue of easy credit conditions causing the market to take too much risk.

If we stabilize from here, this problem will be revisited in 18-24 months. However, the day belongs to the Cramers of the financial world.

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