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Another Fed Rate Cut: Too Little, Too Late?

Date: Friday, January 25, 2008
Author: Martin de Sa\'Pinto, Senior Financial Correspondent, Hedgeworld.com

EDINBURGH, Scotland (HedgeWorld.com)—Surprise intra-meeting cuts aside, the turbulence in global equities markets likely will force the hand of the U.S. Federal Open Market Committee, and the next FOMC meeting Jan. 30 could herald a further interest rate cut of up to 50 basis points, according to a research note from the Royal Bank of Scotland's Group Economics section.

"This is the largest U.S. rate cut at a single meeting since 1982 and the odds are that the Fed isn't done yet," noted the RBS team in the note, issued Wednesday [Jan. 23].

As a matter of fact, the Fed's 75-basis-point rate cut on Tuesday [Jan. 22] was even more decisive than the last two intra-meeting (read "emergency") cuts, both in 2001 and both to the tune of 50 basis points. The first came on Jan. 3, 2001 and was, in effect, a response to a groundswell of panic developing around the dot-com bust. The later cut, on Sept. 17, was an attempt to limit the financial damage when the market re-opened following the Sept. 11 terrorist attacks. The price plunge that U.S. markets saw Tuesday was not as heavy as that on the day following the attacks, though it shaped up pretty badly, with the Standard & Poor's 500 stock index down more than 4% within minutes of the open and Nasdaq Composite losses close on 5%.

In spite of the aggressiveness of Tuesday's move, said RBS, it would be some time before the economic effect could be felt. Moreover, given the seven-week period between the January and March meetings, the research team said a further rate cut, perhaps to the tune of 50 basis points, could arrive sooner rather than later in the effort to improve sentiment and restore order to the markets. Nor would such a cut necessarily signal the end of interest rate tightening. The attempt to head off a recession will be bolstered by a fiscal spending package amounting to 1% of gross domestic product.

But according to some experts, that won't be enough. "Whatever the Fed does at this point is too little too late; we are already in a recession," said Nouriel Roubini, professor of economics and international business at the New York's Stern School of Business in an interview.

While accepting that rate cuts could conceivably bring some short-term relief in terms of available liquidity, Mr. Roubini said he believes the work-through is going to take a lot longer. "It's like pushing on string," he said. "It takes years to work out problems of insolvency, and besides, 200 subprime lenders and dozens of home builders have already gone out of business. The mess has been made, the consequences may be severe and even trying to address the problem may trigger a greater credit crunch in the short term."

According to the RBS note, too, the Fed's somewhat frantic measures "could ultimately result in overkill. Though hardly a near-term concern, overheating and inflation could become the chief risk by some time in 2009." Inflation fears indeed have been a concern in recent months, with an almost unprecedented growth in liquidity—as evidenced by the supposedly precipitous rise in M3 (numbers that have been basically top secret since November 2005) driving asset prices until recently. Indeed, the researchers attributed the recent spike in gold prices at least in part to increasing risk aversion and growing inflation fears.

Elsewhere RBS expects the Bank of England to lower rates by a quarter of a point on Feb. 7, "although the risk that a more aggressive policy response is required is clearly growing." In the European Union there are conflicting forces. With the consumer price index reading of 3.1% soaring uncomfortably above the 2% target ceiling, and with consumer buying power eroding apparently across the EU, broad-based pressures for pay hikes—also known as wage inflation—are also growing. On the other side of the coin, investor sentiment is low, spending is slowing and the strong euro is hampering export-oriented business. For this reason, said the RBS team, the European Central Bank may, too, be pushed to loosen monetary policy by cutting interest rates.