In case you didn't notice ...

The FOMC (Fed) decided to cut another quarter percentage point to take the federal funds rate down to 4.5%. The accompanying comments suggest that the Fed is now taking a sideline approach and contents that its job is done relative to preventing the worst adverse effects on the US economy from the housing market slump which of course is lingering on. The decision itself was a bit surprising for me but clearly in the light of the recent week's tunes of the market war drums it was entirely expected too. Obviously, Bernanke and the FOMC are going to accused to for inducing moral hazard and I have to say that it does seem like markets have boxed the Fed in on this one but at the end of the day this was also I guess a touch and go decision based on economic and market fundamentals. The EUR/USD obviously shot up but not to the extent that you could have expected in the sense that many had been looking for a persistent level above 1.45. This seems to be rather unsustainable which perhaps is underpinned by the steady slew of bad economic data coming out on the Eurozone. In reality the ECB is now faced with the mother of all trade-offs on the back of the recent nasty inflation reading well above target. This means on the bottom line that the EUR/USD pair is indeed trading high at the moment at around 1.4489. As I have argued many times before, this is really a question of 'over to you' Trichet. In terms of FX, I am still quite happy holding my funny money short EUR/USD taken at 1.4433. Don't miss the Yen either which moved above 115 Yen per Dollar as risk appetite (carry trades) resumed their traditional course as well as of course the BOJ's decision to keep rates on hold had something do with this although this was basically a foregone conclusion. Regarding the comments on today's decisions I feature some below ...

(from Bloomberg)

The Federal Reserve cut its benchmark interest rate by a quarter point to 4.5 percent and signaled it's reluctant to reduce borrowing costs further.

``Today's action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets,'' the Federal Open Market Committee said in a statement after meeting today in Washington. ``After this action, the upside risks to inflation roughly balance the downside risks to growth.''

Policy makers lowered rates for a second month even after reports today showed the economy expanded more than forecast last quarter and companies stepped up hiring. The Fed statement also warned that higher energy and commodity prices may spur faster inflation.

FOMC text ... (from Bloomberg)

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 4 1/2 percent.

Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance. However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction. Today's action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.

Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; William Poole; Eric S. Rosengren; and Kevin M. Warsh. Voting against was Thomas M. Hoenig, who preferred no change in the federal funds rate at this meeting.

In a related action, the Board of Governors unanimously approved a 25 basis point decrease in the discount rate to 5 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve banks of New York, Richmond, Atlanta, Chicago, St. Louis and San Francisco.

Comments

[Ravenor]

I see the Fed's cuts as making sense primarily in terms of helping banks' cash margins by widening the spread on loans they have outstanding that aren't in default. Banks that might be on the edge of solvency could be pulled back from the brink of receivership depending on their size.

Even though the Fed Funds rate has been lowered, there's still the issue in the interbank market of counterparty risk. I don't recall if it was the Fed Funds rate or LIBOR but recently one day's intraday data showed a high of 15%. So there are still confidence issues.

I could see the Fed raising by a quarter point by the end of the year depending on what happens with GDP. I think Trichet still needs to raise given the data that you point out.

[CV]

Hi Scott,

Yes, you are right, the interbank debacle should be remembered here. This is clearly set to linger on for some time since 'confidence/credibility' once faltering won't be restored easily.

'I could see the Fed raising by a quarter point by the end of the year depending on what happens with GDP. I think Trichet still needs to raise given the data that you point out.'

This is of course one of the main questions at this point; inflation v underlying growth dynamics. As long as the EUR/USD is trading above 1.40-1.41 I don't think the ECB will raise. Actually, I am quite sure that they won't raise in the 2007 although of course those inflation numbers might just become too big for them to disregard. The point I want to emphasise is that such a move by central banks in general to really give inflation one over the neck would have a very assymmetric effect and I think we are at a point in time where other countries might risk following Japan's path into perpetual deflation if the wheels really get into motion. At least, there are some countries within EU27 which could end up completely on the back if this were to happen.