The Well-Anticipated Rate Cut
The Federal Open Market Committee voted today to lower the fed funds target 25 basis points to 4.50 percent. One FOMC member dissented. Voting against was Thomas M. Hoenig, who preferred no change. The rate reduction action followed a 50 basis point rate cut at the September meeting. In a related action, the Board of Governors unanimously approved a 25 basis point reduction in the Discount Rate to 5.0 percent. This action followed a 50 basis point reduction on August 17 and a 25 basis point reduction in September.
The Committee’s statement emphasized that “Today’s action, combined with 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.” The statement recognized that “readings on core inflation had improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation.” The FOMC noted “that some inflation risks remain” and that the Committee “will continue to monitor inflation developments carefully.”
Prices of futures and options on fed funds had indicated that market participants expected a rate cut of 25 basis points today. Before the meeting, the implied probability of a quarter-point cut was about 70 percent, based on options data. The odds of both a half-a-point cut and no change outcomes were both between 10 percent and 15 percent.
The period since the September 18 FOMC meeting has seen markets settle some relative to the previous intermeeting period. This was apparent in term libor rates. Libor, which stands for London Interbank Offered Rate, is the rate of interest at which banks offer to lend money to one another in the wholesale money markets in London. Because these interbank loans are not secured by collateral, rates on term lending rise relative to the fed funds rate when markets become skittish. Since the last FOMC meeting, both one-month and three-month libor rates fell relative to the fed funds rate, indicating a greater willingness among banks to engage in unsecured lending. Though risk premiums appear to be lower, few participants believe that financial conditions are back to normal.
Moreover, the Trading Desk at the New York Fed held rates much closer to the intended rate than they had in the previous intermeeting period. This signaled that the Trading Desk faced more normal conditions in the market for overnight borrowing.
The settling of markets in the intermeeting period and a strong employment report initially led market participants to expect the Fed to hold rates steady at today’s meeting. Such an expectation seemed to be confirmed by the FOMC meeting minutes that were released earlier in the month. In recent weeks, however, incoming data revealed that the housing market was even weaker than had been anticipated. The magnitude of the drop in residential housing investment amplified markets’ fears that unchecked momentum in housing could spill over into other sectors, raising the risk of recession. Markets have come to expect another rate cut in December of at least 25 basis points.
In its assessment of risks, the FOMC statement noted that the Committee “judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth.” The immediate reaction to the statement was largely negative. Equity prices fell, erasing gains on the day. Within minutes, however, market sentiment turned favorable and equity prices rose to new highs on the day. The Dow ended the day up 1 percent. Odds on another rate cut in December backed off to less than 50-50. The yield on 10-year Treasuries rose 9 basis points.