Steering Clear Of Aggressive Fed Cuts

Cutting interest rates in the US 100 basis points by the end of the year would be a little like taking a car from zero to 100 in six seconds flat. Auto analogies aside, markets may already be getting carried away on how much the Federal Reserve is willing to respond to the current volatility in housing and financial markets with a slew of rate cuts.

Talk about an over-acceleration that is likely to burn out the engine. Auto analogies aside, markets may already be getting carried away on how much the Federal Reserve is willing to respond to the current volatility in housing and financial markets with a slew of rate cuts. Fed chief Ben Bernanke is still playing coy. Sure, he said in his speech Friday the central bank "stands ready to take additional actions" to boost liquidity. But what else would he be expected to say? No, we would continue to sit idly by if things descended into chaos? And sure, he said "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." But he noted in turn that "it is not the responsibility of the Federal Reserve, nor would it be appropriate, to protect lenders and investors from the consequences of their financial decisions." (President George Bush also said it's not the government's job to bail out real-estate speculators.) That line from the current Fed chief is the delineation between Bernanke and his predecessor, Alan Greenspan. Bernanke and his cohorts on the Federal Open Market Committee may indeed cut rates 25 basis points later in September. But markets may be getting ahead of themselves in predicting aggressive action in coming months. The economy looks to be idling in the US, according to some mixed economic data of late, but it is not an economy yet under major pressure. Some would argue the Fed needs to act quickly, given the lagging effect of rate cuts, to minimize the reaction if the economy were to sink later under the weight of a housing market collapse. But so far officials haven't indicated this is a scenario they are entertaining. Any rate cuts for now would be about sentiment more than anything else, to reassure markets. That should keep rate cuts to a minimum. Martin Feldstein, a professor at Harvard and head of the National Bureau of Economic Research, in closing remarks at the Kansas City Fed's annual Jackson Hole, Wyo., conference over the weekend, said the Fed should lower the federal funds rate as much as 1 percentage point. While any rise in inflation resulting from the rate cuts would be an "unwelcome outcome," Feldstein added it is "the lesser of two evils." That view seems to be shared by rate futures markets in the US, but these markets are notoriously volatile, and do get ahead of themselves. That could mean a repricing of positions will be needed in coming months. For now, the December federal-funds contract fully prices in a 4.5% rate by the end of the year, and shows 85% odds for an additional rate cut to 4.25%. Rates at 4.25% by the end of this year? Hard to justify at this point.