Fed Reluctant to Cut Rates This Week

Bernanke is hoist on his own petard. He and the members of the FOMC had hoped that their dramatic cut in the Fed funds rate in September would be enough of a balm to the markets to give them more policy latitude in later months. Instead, the markets took it as a signal that Uncle Ben is their best friend, and they are lobbying for more, via the expectations signaled in futures prices. Now the FOMC is hostage. If they do what they think is right for the economy, they might roil the markets.

I wish we had Volcker back. He was more willing to inflict short-term pain for long-term benefit. A further rate cut will do nothing to shore up the areas of the market where the troubles lie, such as SIVs and CDOs. Certain types of mortgage-related assets are either not trading at all, or would trade only at distressed prices, due to problems of credit quality and transparency. A rate cut will not fix either problem.

From Bloomberg:

Federal Reserve Chairman Ben S. Bernanke and his colleagues sound as if they’d prefer to just say no to an interest-rate cut this week. The financial markets may not let them.

Policy makers from Bernanke on down have avoided signaling they want to reduce benchmark lending rates at their Oct. 30-31 meeting, ever since lowering them by a larger-than-anticipated half percentage point in September. Instead, Fed officials have stressed how uncertain the outlook is and, in words Bernanke used twice in a single week, how “challenging” it is to make policy.

Traders don’t agree. They consider the chances of a rate cut this week as a cinch, judging from federal funds futures prices at the end of last week. If the Fed disappoints them, it risks upsetting still-fragile markets and hurting the economy.

“The Fed is reluctant to ease,” says Louis Crandall, chief economist at Jersey City, New Jersey-based Wrightson ICAP LLC, a unit of ICAP Plc, the world’s largest broker for banks and other financial institutions. “But it also doesn’t want to unsettle the financial markets unnecessarily.”

The likely rationale if the Fed cuts: a desire to prevent the worst case, in which renewed market tumult, rising oil prices and falling home values drive the U.S. economy into recession.

The Fed, though, may combine such a move with an open-ended statement that doesn’t promise further cuts. Its goal would be to dissuade investors from anticipating a series of reductions, an outlook that could further weaken the dollar and revive inflation concerns….

“The markets are yo-yoing all over the place,” says former Fed Governor Lyle Gramley, now a senior economic adviser at Stanford Group Co. in Washington. “The Fed ought to have a cooler head.”….

Anecdotal information the Fed has gathered from business contacts, which has more weight in uncertain times, shows the economy expanding, albeit at a slower pace than when the central bank’s Federal Open Market Committee met last month….

Policy makers, including San Francisco Fed President Janet Yellen, have also highlighted the economy’s ability to weather financial turmoil in the past as reason to avoid overreacting to the latest market squall.

They cite 1998, when stocks slumped and credit costs rose after the collapse of hedge fund Long Term Capital Management in September. Helped by three rapid-fire rate cuts by the Fed, the economy barreled ahead, growing by 6.2 percent in the fourth quarter….

The Fed tried to avoid a similar situation last month with its half-point cut, says Laurence Meyer, a Fed governor from 1996 to 2002 and now vice chairman of Macroeconomic Advisers LLC of St. Louis. Instead, it once again faces calls for another cut. And traders are betting it will comply once more, if only to short-circuit a renewed increase in borrowing costs in credit markets.

Update, 10/29, 4:45 PM: Further observations from the Nattering Naybob:

No cut on Oct 31st means BIG disappointment. Cut?? Initial glee, but then we could see a redux of Jan 31, 2001 rather than the 1998 scenario.

Between June 99 and May 00, the Fed raised to 6.5%, then held for 7 months. During which the Dot.com implosion began the stock market slide in Mar 2000.

In a surprise meeting 01/03/01 the Fed cut 50 bps, the markets rocketed to the upside for 4 weeks.

At the regularly schedule meeting on 01/31/01; The Fed cut another 50 bps. The market initially jumped up then closed down that day.

Looking at a chart it appears after raising, then holding, the 2nd cut reinforced lower economic expectations and a weaker dollar, which sent the market into a 3 year tail spin.

An economic-risk index compiled by Citigroup suggests that credit costs are rising after dropping in the aftermath of the initial 50 bps September rate cut.