December 12, 2007

Yesterday the Federal Reserve decided again to lower the federal funds target rate by another 0.25% -- to 4.25%.  From the Fed’s press release:

“Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks.  Today’s action, combined with the policy actions taken earlier, should help promote moderate growth over time.

Readings on core inflation have improved modestly this year, but elevated energy and commodity prices, among other factors, may put upward pressure on inflation.  In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

Recent developments, including the deterioration in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation.  The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.”

When the Fed met last, on October 31st, and decided to cut rates, it explicitly told us not to expect any future rate cuts.  But the economy has performed more poorly since the 31st than the Fed had hoped.

One of the Fed’s primary concerns is balancing inflation (the rate at which prices rise) with economic growth.  If the Fed cut rates too much, inflation could rise to dangerous levels (where prices are increasing much more quickly than our wages); if the Fed doesn’t cut rates enough, the economy could stagnate or fall into a recession.  It’s a delicate balancing act.  And judging from the Fed’s statement yesterday, it remains poised to cut rates further if the economic situation doesn’t improve.

Mortgage rates fell yesterday on the Fed’s announcement – the average rate on a 30-year fixed-rate mortgage fell to 5.75% and the 15-year fixed rate dropped to 5.35%.  That’s expected – if the banks lend each other money more cheaply (the fed funds rate falls), they can lend it to you more cheaply (at a lower interest rate), too.

Yet, surprisingly, the stock market was down after the Fed’s announcement.  Typically, the stock market rallies when the Fed cuts rates (because investors believe the rate cut will stimulate the economy and want to buy before stocks rise in value).  But yesterday, investors were disappointed by the quarter-point cut; they had hoped that the Fed would cut rates by a half-point. 

From the Reuters report:

Stocks fell sharply on Tuesday after the Federal Reserve cut interest rates by a quarter-percentage point, disappointing investors who had hoped for a more aggressive rate reduction.

The U.S. central bank cut the fed funds rate to help the U.S. economy withstand tightened credit and a prolonged housing slump. While the action was widely expected, some economists had though the Fed might offer a bolder half-point reduction in the rate, which governs overnight lending between banks.

This was the Fed's third straight cut in the key fed funds rate, which brought it down to 4.25 percent from 4.50 percent. The Fed also reduced the discount rate it charges banks for direct loans by 25 basis points to 4.75 percent from 5 percent.

"The 25-basis-point cut was more than priced into the market. Many traders were expecting a 50-basis-point cut and when that did not occur, the disappointment was met with heavy selling in stocks," said Tim Biggam, lead option strategist at online brokerage thinkorswim, in Chicago.

The Federal Open Market Committee (which decides the Fed funds target rate) will meet again in late January.  If the housing slump, credit crunch, and oil squeeze haven’t eased their hold on the U.S. economy, the Fed may have to act again.