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Market Update -- Economic Comment

Written by Jane Caron, CFA, Chief Economic Strategist

April 30, 2008

As expected, the Federal Reserve reduced the funds rate by 25 basis points to 2%. Also, as expected, the statement that accompanied this move reinforced the notion that the Fed is ready to step to the sidelines while they assess the impact on the economy of fiscal and monetary stimulus applied to date. Another important reason for the Fed to step aside at this time is that inflation pressures remain elevated and inflation expectations appear to be rising. A third issue is the dollar. The dollar has started to stabilize in reaction to the thought that the Fed is ready to pause, and this has helped reduce upward pressure on commodities prices, which, in turn, has diminished a key headwind for consumption growth. In other words, the Fed might actually do more to promote economic growth by keeping policy steady in coming months than loosening it.

These are all reasons that our federal funds forecast anticipated that the Fed would pause around now, only we had thought that the Fed would probably cut rates another 25 basis points in June before pausing at a funds rate of 1.75%. That could still prove to be the case should inflation pressures subside and economic data released between now and then prove to be notably worse than the Fed expects. I am assigning 60% odds that the Fed will cut the funds rate to 1.75% versus 40% odds that they will pause here.

Regardless of whether the Fed pauses at 2.00% or 1.75%, the key issue for us is that the pause could prove temporary. This is because, unlike the Fed, we do not believe that the economy will be growing at or near its potential rate in 2009. We expect GDP growth of just 1.5% in 2009 following growth of slightly less than 1% in 2008. Therefore, we believe the Fed will be predisposed towards easing policy again as it becomes evident that economic growth is going to once again undershoot their forecast. The bugbear, however, is that inflation pressures will need to subside in the second half of 2008 in order to give the Fed scope to ease later this year or early next year. Our forecast anticipates a reduction in inflation pressure due to sub-par economic growth, but we are the first to say that forecasting food and energy prices in this environment requires a stronger crystal ball than the one we possess. If commodity prices simply stabilize, however, that will take some pressure off the Fed. We are hopeful that this will happen.