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Market Update -- Economic Comment

Written by Jane Caron, CFA, Chief Economic Strategist

August 27, 2007

The markets are priced for a 25-basis point cut in the federal funds rate on or before the September 18 FOMC meeting followed by another 50 basis points in cuts by spring. Chairman Ben Bernanke is surely thinking about these expectations as he prepares his speech for the FRB Bank of Kansas City's Jackson Hole Symposium on Friday, 31 August. A failure to cut the funds rate at the September FOMC meeting could deeply unsettle the markets if investors are not forewarned, and this speech provides an opportunity to adjust market expectations.

Chairman Bernanke is in a difficult situation, though. He made it clear last May after he unintentionally shared market-moving thoughts with CNBC reporter Maria Bartiromo that "in the future my communications with the public and the market will be entirely through regular and formal channels." Bernanke could consider his speech a "regular and formal channel," but his prepared text will not be released on the Fed's website. His comments will be widely reported, though.

The FOMC, based on public comments by members, is not anxious to reduce the federal funds rate. This is because there is skepticism by at least some members that the revaluing of risk in the credit markets—a needed adjustment that should be aided not opposed—will overly disrupt the economy. The ten voting members of the FOMC will undoubtedly have differing opinions on the extent that the financial market malaise is curtailing economic growth, and this will make it difficult to reach an agreement about the proper course of action.

This week, the minutes from the August 7 FOMC meeting will be released. It is possible that these minutes will include a section on the August 16 conference call that led to the revised policy statement released August 17:

• Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.

It is clear from this statement that FOMC voting members are concerned about downside risks to the economy, but it is not clear that they are concerned enough to reduce the federal funds rate in September. Hopefully, the minutes and Bernanke's Jackson Hole speech provide some clarity. We believe that the downside risks are significant enough to warrant a 50-basis point cut in the funds rate in September, but we are doubtful that the FOMC will take such aggressive action. A 25-basis point cut seems more likely, but the risk is that they do not cut at all.