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Briefing.com Free Services: Fed Brief: A Strong 50 bp Finish?

The FOMC surprised the markets with an unexpectedly strong 50 bp ease in both the federal funds rate target and the discount rate. The 1.25% funds rate target is the lowest in 41 years as you have to travel past our 56 year history to find a discount rate lower than the new 0.75%.

The 12 member FOMC vote was unanimous despite a presumably heated discussion around the Fed's mahogany table. The strong 50 bp ease after 11 months of on-hold policy came with a return to a neutral policy bias (risk assessment) as the 'current soft spot' in the economy was partly blamed on heightened geopolitical risks.

Our interpretation is that the FOMC is confident (hopeful) that the strong 50 bp ease will be enough to put the economy back on track. The neutral bias is intended to signal that a Dec ease is not currently on the table despite that the geopolitical risks should be present far longer than year end. Added fiscal policy stimulus may lend a hand given the Republican control of Congress.

The large 50 bp size was intended to impress the markets and provide an added thrust to the recovering stock market, support consumer spending and lower corporate borrowing costs. The outlook for business investment has improved marginally but will remain weak given the weight of excess capacity.

The policy statement read:

The Federal Open Market Committee decided today to lower its target for the federal funds rate by 50 basis points to 1 1/4 percent. In a related action, the Board of Governors approved a 50 basis point reduction in the discount rate to 3/4 percent.

The Committee continues to believe that an accommodative stance of monetary policy, coupled with still-robust underlying growth in productivity, is providing important ongoing support to economic activity. However, incoming economic data have tended to confirm that greater uncertainty, in part attributable to heightened geopolitical risks, is currently inhibiting spending, production, and employment. Inflation and inflation expectations remain well contained.

In these circumstances, the Committee believes that today's additional monetary easing should prove helpful as the economy works its way through this current soft spot. With this action, the Committee believes that, against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are balanced with respect to the prospects for both goals in the foreseeable future.

Effects

A reduction in interest rates is positive for the economy. Lower borrowing rates boost profits and improve the outlook for the equity markets. Corporate borrowing costs decline and economic demand turns stronger with lower financing costs. And in the topsy-turvy world of deflation fears, increased money growth provides liquidity and over the longer term an upward force on inflation (which will come back to haunt).

However, the broader restraints on consumer and business confidence won't be greatly affected. Lower overnight rates simply won't soften the war or terror concerns which undermine the market pessimism. The labor market and manufacturing sector may be marginally improved but the strong constraint on business investment (both in labor and capital goods) isn't lessened. The large supply of excess capacity is directing investment, not the inexpensive cost of financing it.

Tim Rogers