Fed Cuts by 25bp, Move Disappoints Even Though Statement is More Dovish

The Federal Reserve cut both the Fed funds and discount rate by 25bp to 4.25 percent. Even though the balance of risk statement disappeared making the tone of the FOMC statement more dovish, the move by the Fed was disappointing. Traders were looking for a larger cut of the Fed Funds rate or at least a 50bp discount rate cut. Unfortunately, the Fed’s Christmas present was too stingy.
Stocks are down sharply, carry trades have plummeted and the US dollar has strengthened across the board. The dramatic shift in price action represents a market that is readjusting its expectations. The intraday reversal however may prove to be exaggerated because the statement contained cause for concern. It reeks of caution as the Fed acknowledges the slowdown in economic growth, the intensification of the housing market correction and the softening of business and consumer spending. They still feel that inflation could rise, but the upside risks to inflation no longer balance the downside risks to growth. This has caused Rosengren to vote in favor of a 50bp rate cut. Last month’s decision was also not unanimous, but at that time, Hoenig voted in favor of leaving interest rates unchanged. The probability of a recession is at the highest level in more than 3 years according to the latest WSJ.com survey. Fed fund futures are still pricing in 2 more rate cuts in 2008. The dollar could rally for the remainder of the week, but we expect weakness to resume as we get closer to 2008. The Dow and Carry Trades should also suffer more losses this week.

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