PRINTMarket Update -- Economic Comment
October 22, 2007
Investors have their knickers in a twist again and are looking for the Fed to smooth things out. Treasury yields sank 25-to-45 basis points across the curve last week in response to sharply lower equity prices, weak economic data, and continued trouble in the asset-backed area. The surprise for us is that none of last week's news should have been surprising. Economic growth is set to materially slow, and there is a 30% probability that the economy will be in a recession next year. This is the story of the Three Little Pigs, not Goldilocks. While our forecast assumes that the brick house will stand, we think there will be cracks in the mortar.
Investors are currently assigning 90% odds that the Fed will loosen monetary policy at the October 31 FOMC meeting. Investors were assigning just 33% odds a couple of weeks ago. While we have a below-consensus forecast for the Fed to loosen monetary to 4% next year, we think the odds for a rate cut in October are closer to a coin flip. There are strong pros and cons associated with changing policy this month.
On the pros side is the downbeat Beige Book, accelerating housing market deterioration, weak employment growth, and increased confidence at the Fed that core consumer inflation will remain tame. Moreover, the next FOMC meeting is not until December 11, which is a fairly long interim period.
On the cons side is the risk that investors will still be uncomfortable with the overall inflation outlook, so worries about continued Fed easing could result in higher, rather than lower, long-term borrowing rates. Also on the cons side is the weak dollar, which could weaken more if official rates are cut again. Finally, the Fed might like to reduce the level of moral hazard caused by their September cut by not immediately following it with another cut. So, even though economic data augur for a rate cut, the environment might encourage the Fed to pause.
While the Fed may stay on hold in October, we think the Fed will loosen monetary policy a few more notches in coming months as the economy slows and core consumer inflation remains inside the Fed's comfort zone. At this time, we do not expect the Fed to have to engage in a marathon easing operation to stave off a recession, but downside risks to economic growth are significant, which means the Fed will have to remain on call.
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