Fed Sensitive To Pulse Of Economy, Not Markets

Amid the growing calls for the Federal Reserve to step in and "save" markets from their current misery, it's important to remember the Fed is concerned with the overall monetary system as it relates to the economy as a whole, not with particular markets or financial institutions.

As baseball commentator Joe Garagiola once said: "God answers all prayers, but sometimes the answer is `No'." The financial market free-fall is certainly on the Fed's radar screen, but it's doubtful that the chorus from market participants calling for a Fed rate cut that grows with each stumble of the major indexes will be heeded. Almost all asset classes are in the red Thursday. The broad-based nature of the selloff confirms that the repricing of risk is no longer confined to the subprime mortgage market. Nevertheless, unless there is a major seizure that threatens the normal functioning of the financial system and hurts the economy directly, it's doubtful the Fed will choose a rate cut to stave off the sharp drop in markets. "So far we see it as mostly a market event, and not yet something that will really hurt the economy," said Lakshman Achuthan, managing director at the Economic Cycle Research Institute. It "will be interesting to see how the final weeks of summer play out." That doesn't mean the Fed will ignore financial markets, but when it comes to interest rate decisions, chances are it will monitor how the liquidation of credit assets will translate into the behavior of consumers and businesses as a whole, not simply a portion of the housing market. If banks are unable to securitize loans and forced to rein in their lending, that will directly impact consumption, housing and by extension the outlook for overall economic growth. That's when the Fed will likely consider using its short term rates to encourage lending. But until the evidence shows that consumers are postponing purchases, the Fed will more likely continue to deal with the market turmoil through capital market operations such as repurchase agreements as they have in recent days.

Evidence From The Real World

"To be sure, the recent tightening in financial conditions is bound to have some negative impact on growth, but it may just amount to a few tenths if the financial markets can find some way to stabilize in the near-term," wrote Deutsche Bank economists Joseph A. LaVorgna and Carl J. Riccadona in a research note. "In 1998, the economy did not have any lasting damage from the LTCM crisis, as real GDP (gross domestic product) growth rose over 6% in the fourth quarter. It is still possible that the economy can emerge from the current financial market funk relatively unscathed," they wrote. So far, it's hard to see that any economic activity has been derailed by the current credit crunch in financial markets. Consumers are still shopping and nonfinancial businesses are humming along as usual. The latest regional business activity data, for example, fails to give conclusive evidence of a sharp slowdown. The fact that the Philadelphia Fed index was unchanged in August means that manufacturing activity "was generally steady in August," said Mike Trebing, senior economic analyst at the Philadelphia Fed in a telephone conference after the release of the data. On Wednesday, the Fed's own industrial production index, an indicator the central bank watches closely, increased 0.3% in July, with a 0.6% rise in manufacturing, only held down because of a weather-related drop in electricity generation. And while the 6.1% drop in housing starts for July brought the decline to date to 39.3% from the peak in January 2006, that drop, though large, is very much in line with the average decline in the past three housing downturns. Because the brunt of the financial market selloff has been taking place in August, some observers have dismissed the strength in the July data as historical. The Fed certainly understands that because riskier mortgages that have buoyed the housing boom since 2001 are no longer a viable option, consumers may pull back in several key areas of the economy until a new source of credit becomes available. Should that occur, a cut in the Fed's key short term rate could have a broader impact in order to restore economy-wide credit conditions. In any event, the Fed isn't ignoring current financial conditions. It has supplied extraordinary amounts of liquidity through its open market operations - the routine way in which the central bank helps markets function. In this way, the Fed actually eases conditions in credit markets, something that a rate cut would not automatically accomplish. The Fed will keep an eye on things to be sure that the financial markets keep running, but in the absence of a broadly perceived crisis - such as happened after the terrorist attacks on Sept. 11, 2001 - it's hard to see the Fed taking extraordinary action on interest rates.