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Wait, The Fed May Cut Again?!?

Posted on: September 15, 2008 - Email Article - Printable Version

Charles W. Petredis

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Yes, it is actually a possibility, contrary to popular belief. Many of you are probably wondering if I am insane for writing this, but I would tell you not to rule this option out. I am in no way predicting or guaranteeing that the Federal Reserve and Helicopter Ben are going to lower the funds rate again, but I would not put it past them. If you step back and look at some of the underlying economic issues that are driving his decision, you will understand why Ben Bernanke and the other FOMC governors might not be completely out of their minds.

Inflation is high, or is it?

The answer to this question might depend on with whom you are talking and what your time frame is regarding the subject. Let us take a look at the most recent numbers.

CPI - Consumer Price Index - 5.6%
PCE - Personal Consumption Expenditures - 2.4%

The Federal Reserve states that their comfort zone for CPI inflation is between 2.0% and 4.0% while their comfort zone for PCE inflation is between 1.0% and 2.0%. Both of these numbers are above the upper range, and if you were in a grocery store or near a gasoline pump during July, you would be able to feel the full effect of these numbers. One thing that many investors forget is that these inflation statistics are backwards looking, in some cases by a few months. Even if investors understand the nature of these inflation statistics, it is important for them to realize the context of the decision of changing the federal funds rate.

The Federal Reserve’s mandate is to be forward looking, not to react to the delayed inflationary readings that are released every month. If this were the case, anyone could be the head of the Federal Reserve, because there would be no thought entering into the decision. Because the Federal Reserve has to look forward, there are facts that the general public cannot know that affect the decision.

Deflationary pressures get no love

Regardless of what the media may be reporting, deflationary pressures are real and exist even in a market environment such as this. Consider some of the more subtle hints that we have seen materialize over the last few weeks. Firstly, the Monetary Base has actually shrunk over the last month. This means that the Federal Reserve and Big Ben are not just running the printing presses at non-stop rates, even though so called “financial experts” will tell you otherwise. Secondly, the Federal Reserve has reported that during September the Term Auction Facility (TAF) has actually not been used, not even once. With rates this low, it does not mean liquidity is drying up, but that at least for the time being these banks have determined that they do not need any more emergency funds from the Federal Reserve.

There is also the matter of employment. Unemployment is at a 4+ year high which is actually a positive thing when it comes to inflation. When unemployment is high, there are more people looking for jobs. These people looking for jobs are perfect replacement workers for firms. Because there are a lot of replacement workers in the system, firms have no need to raise wages; if a worker won’t work for his current wage, he can be easily replaced. When wages are not increasing, a major force downward on inflation occurs. If you want to take a look at an even larger scope, there is a world wide economic slowdown over the world. With much higher unemployment rates around the world, especially in Southeast Asia, you can expect that world wages will stay low in both the short and intermediate term. These flat wages are going to keep consumers spending less than before, and in order for firms to compete they will have to keep prices low.

Conclusion

While I do not think the Federal Reserve should lower the federal funds rate any further, I will be the first person to tell you that Ben Bernanke is more experienced and much smarter than I am.
The next FOMC meeting is September 16th, 2008, and the results will be released around 2:15 PM EST. If I were a betting man, I would bet for a hold at 2.0%, but the complexity of this decision leads me to believe that no one besides the 12 people sitting in the board room has any idea what is going to happen.

- Charles W. Petredis

Disclosure: None.

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