The Fed in its cul de sac

Escrito el 30 octubre 2007 por Juan Toro en Financial Markets

Tomorrow the Fed will make a decision about moving rates. Markets have fully priced a 25 basis cut and are giving little room to the Fed to alter the general consensus. Contradicting markets and leaving rates unchanged is a possibility but one that the Fed might not follow in these volatile markets. There are three possible scenarios for the Fed: a cut of 50 basis points, a reduction of 25 basis points or leaving the key rate unchanged. Markets reckon that the only possible scenario is the 25 basis points reduction and this has been priced by the markets. This view is supported by a softening of the labor market, shaky foundations of the mortgage market and a declining housing market (that might affect consumption soon). The 50 basis cut might be supported by news unknown to the general public on credit conditions, but carries the peril of a collapse of the dollars (with corresponding inflationary pressures). The no reduction option could have seemed the more logical and would buy time for the Fed to analyze and asses incoming data. However this is an option, that given market expectation, might not be feasible. The Fed has not been able to communicate the needed uncertainty to transmit markets some odd of a no cut movement. The Fed has let markets price a 25 basis point change and has not been able to transmit any other option. Given market expectations the Fed decision process seems irrelevant. The Fed will not leave rates unchanged unless they are ready to face wild markets. A better communication process might have left the Fed with wider options.


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