The Hindu Business Line : US data justify 50 bps cut

It is ‘the’ event for financial markets – the bimonthly meeting of the Federal Open Market Committee (FOMC for short) on December 11 to decide on US interest rates. Correct it to ‘which tries to set US interest rates’.

For, in recent months, that has become the issue. The Fed has two benchmarks – the more known and watched ‘Fed Funds’ , the rate at which banks lend to one another in the overnight market and the ‘discount rate’, the price it charges to lend to banks. The first is approximately where the Fed wants the interbank money market to be, considering economic and financial market conditions. It will inject or remove daily liquidity to keep the market rate close to the Fed Funds benchmark.

Interbank rates

Of late, it has not been particularly successful. Interbank rates are tens of basis points above current Fed Funds of 4.5 per cent. In normal times, the spread is of the order of a few basis points, often below the benchmark. But these are anything but normal times. Thanks to sub-prime provoking a rash of write-offs and provisioning, the true financial condition of the world’s biggest banks is suspect, keeping interbank rates well north of Fed Funds. Another measure of perceived risk - the difference between LIBOR and the yield on Treasury bills – is almost 200 bps. Credit concerns are defeating the Fed’s moves to soften monetary policy, considering the weakening economy and confidence crisis in financial markets.

For its part, the Fed has slashed its lending rate – its discount (repo) rate - to 5 per cent - only 50 bps more than Fed Funds instead of the usual 100 bps. It might narrow this further to 25 bps at this meeting.

Us jobs

The all-important question is, of course, if the Fed will cut 25 or 50 bps. The slightly more than expected new job creation in November changed the odds in favour of a 25 bps cut. The market ignored the downward revision to the previous two months’ data. It is a sign of the times that payroll additions of just around 100,000 a month are considered highly positive for the economy and negative for interest rates. In the Clinton years, it was normal to see double this number.

Going by his recent utterances, the Fed Chairman, Mr Ben Bernanke, is worried about the economy and not just the credit market seizures. The flow of poor economic figures – falling consumer and business confidence and manufacturing and services being just above recession levels – continues. The Fed’s own ‘Beige Book’ survey of regional business conditions finds activity at best ‘modest’.

Reading between the lines, it seems the Fed’s take on the economy is more pessimistic than the market thinks. And that points to a 50 bps cut.

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