Fed Officials Refuse To Signal Next Rate Action

Financial markets have concluded that the Fed will cut rates at its next meeting on 18 September, though Fed officials have failed to offer any solid guidance.

Financial markets have concluded that when the interest-rate setting Federal Open Market Committee next meets on Sept. 18, it will lower the official overnight target rate from its current level of 5.25%. Investors believe this for a number of reasons. They see the broad-based troubles besetting credit markets and the housing sector as adding significant headwinds to an economy already growing at modest levels. At the same time, they reckon the Fed has new latitude to ease rates because inflationary pressures have recently settled inside central bankers' unofficial range for an acceptable inflationary environment. At the same time, the Fed has helped fuel some of these rate cut expectations, albeit indirectly. The U.S. central bank has at various periods over recent weeks intervened heavily to add liquidity to financial markets - it did so again Thursday, in spades - driving the actual level of the funds rate under the official target, in what many view as a "stealth" easing of policy. It has also liberalized borrowing terms at its emergency funding tool, the discount window. What's more, in an unusual move, the Fed also issued a statement several weeks ago that ended its official view that inflation is the biggest threat to the economic outlook. A so-called inflation bias suggests that if the Fed were to take any action, it would be to hold or raise rates, not cut them. Its removal opens the door to a rate cut. Former Dallas Fed President Robert McTeer noted in a recent editorial in the Dallas Morning News that, "while an inflation bias doesn't preclude easing, it does make it awkward," suggesting the Fed wanted to give itself the space to act, even if it doesn't. And yet, Fed officials themselves have been decidedly noncommittal when challenged directly about the rate outlook. They argue they are still watching the data and are still trying to decide whether the sort of response they have taken so far is sufficient, or whether a more dramatic step might be needed. Thursday was no different. "I am still forming my own assessments" about what should be done with monetary policy, said Dallas Fed President Richard Fisher, speaking in Las Cruces, N.M. The former hedge fund operator also downplayed what the market thinks the Fed will do, saying "I am not going to comment on market expectations. They come and go."

Housing Market Woes May Implicate Broader Economy

The Fed officials who spoke Thursday did acknowledge that what has happened in markets, along with the housing sector, may harm the broader economy, an area central bankers have been vociferous in stating is their primary mandate. "We have seen a fairly sharp downturn in housing markets," Fed Governor Randall Kroszner said at a conference held by the San Francisco Fed. "If current conditions persist in mortgage markets, the demand for homes could weaken further, with possible implications for the broader economy." The Fed governor said his comments were meant to "reinforce" views held by Fed Chairman Ben Bernanke, who told a recent Fed conference "developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy." Still, Dennis Lockart, the newly installed head of the Atlanta Fed, said in a hometown address that "the picture isn't conclusive that financial market troubles have translated into serious difficulties in the broad economy." He added, "we will continue to monitor all of those indicators.. and take the necessary action as things change." St. Louis Fed President William Poole also remained cautious in stating his assessment of events. Speaking in London, the policy maker said of the market's tribulations: "The extent to which it's affecting the broader economy...I don't think we know yet. We shouldn't take for granted the assumption that the economy is about to take a nose-dive." Poole, who astonished many investors several weeks ago for what they viewed as overly sanguine take on the market troubles, added "what is not clear at this point is what the right policy response is to the changed circumstances." The market's widely held expectations about Fed policy and central bankers' apparently unwillingness to endorse them creates an unusual environment, at least relative to the experience of recent years. And that is that the upcoming FOMC meeting has the very strong chance of surprising market participants who have usually been dead on in expecting rate meeting outcomes. The risk for the Fed is that disappointing market expectations could reintroduce volatility at a time when it's been on the wane. But if the Fed cuts rates, it may also be interpreted as doing so because it fears disappointing investors. It risks creating the impression that it is acting to bail out investors who made a bad call, thus boosting the chance investors will follow similar paths in the future, confident the Fed will save them if they run into trouble. It's a high stakes game.