The release accompanying the Fed’s 50 b.p. rate cut on 18 September stated that the move was intended to forestall the adverse effects of tighter credit conditions. Credit markets have yet to normalise fully but are moving in the right direction. For example, the spread between the discount rates on three-month non-financial commercial paper and Treasury bills has fallen from over 100 b.p. at the time of the last Fed meeting to 60 b.p. currently. An earlier post argued that such a decline would support a forecast of contained economic weakness.
Economic news since the last meeting has been no worse than feared. August’s 4k decline in payroll employment, which provided convenient cover for the Fed’s 50 b.p. move, has since been revised to a gain of 89k, with a further rise of 110k reported for September. Third-quarter GDP figures tomorrow are expected to show annualised growth of about 3%, although a softer number is likely in the fourth quarter, reflecting higher energy costs as much as the “credit crunch”. Housing data have been weak but there are signs that activity is bottoming.
The Fed’s policy decisions have significant spill-over effects globally, particularly in emerging markets, where exchange rate links to the US dollar result in monetary conditions mirroring US developments. Policy-makers have been trying to restrain economic expansion in many emerging countries but their efforts were undermined by the Fed’s September cut. The emerging world boom is providing important support to the US economy in the form of strengthening export demand while putting upward pressure on headline (and possibly core) inflation as oil and other commodity prices continue to surge.
Current conditions may be contrasted with 1994 and 1997, when the Fed tightened monetary policy based on domestic considerations while emerging markets were in a weakened state, leading to the Mexican peso and Thai baht crises (December 1994 and July 1997 respectively). These crises fed back into slower US growth and downward pressure on inflation via falls in commodity prices, causing the Fed to reverse policy tightening in 1995 and 1998. The opposite feedback relationship currently implies that any further Fed easing will be limited and may be reversed in 2008.
As should be clear, I am unconvinced of the need for a further Fed move this week. However, officials have failed to intervene to check strong market expectations of another 25 b.p. cut so the default assumption must be that one will be delivered. This would strengthen the parallels between current conditions and 1999, when the Fed pumped liquidity into markets into year-end on concern about possible economic disruption from the Y2K changeover, to the delight of stock market speculators.