The Hindu Business Line : Fed will go 50 bps

Far more than the usual excitement (and, it must be said, anxiety) are preceding this FOMC meet. The G-7 money and bond markets are in near crisis mode. The differential between LIBOR and Treasury bills and the spreads of bonds over sovereign paper have shot up. There are no takers for the hundreds of billions of dollars of asset-backed commercial paper due for refinancing in the next weeks.

Clearly, investors are wary of new commitments in an environment of risk aversion (globally).

A Fed cut is taken for granted, but will it be 25 or 50 bps? And does it think a recession is in store? Fed Chairman Ben Bernanke has not tipped his hand. The views of his FOMC colleagues – at least those who have spoken publicly - are split.

Moral hazard issue

At issue is the age-old problem of ‘moral hazard’. The market should not think the Fed and other central banks will ride to the rescue every time, say the no-sayers. Others feel the erosion of confidence in money markets coupled with the hit to consumers from the housing collapse is serious enough to derail the economy, in which case rapid and drastic Fed action is badly needed.

The doves seem to have more arguments on their side. For one, core inflation is well in the Fed’s range. Recent data, particularly on jobs, have been weak or negative. (Interestingly, this was so even before the current financial market seizures). Also, there is a complete disconnect between the Fed’s benchmark rate and Treasury bill and bond yields. Many economists believe this is a sure recession signal.

Various possibilities

There are various possibilities. If the Fed is confident the economy will ride through the storm, it may send a reassuring message. Or, it could say it is waiting and watching the unfolding situation and stands ready to move if conditions deteriorate. (Mr Ben Bernanke said as much in his Jackson Hole speech to the world’s central bankers a couple of weeks back).

A 50 basis point-cut surely means the Fed’s situation assessment is bad, because if it goes that distance, it must think a recession is highly probable. (Strangely, a number of market players think this will be the cue for a market rally).

The bet must be for 50 bps off. The collateral damage to households’ and banks’ balance sheets from the present crisis is significant, the economy is at risk and one dare says the FOMC knows this.

Rescuing the market from its follies is undoubtedly unsound policy, but is there a choice?

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