Sunday, December 9, 2007

Liquidity before price stability

The fed will cut rates before they know about the latest inflation developments. It shows where the true priorities lie.

From MarketWatch

WASHINGTON (MarketWatch) -- In a glorious bit of timing, the Federal Reserve is expected to cut interest rates on Tuesday for a third straight meeting, just days before government data are released showing some of the highest inflation rates in decades.

That's all you need to know about the Fed's balance of risks: Policymakers are much more worried about the illiquid credit markets and the possible hit that the credit squeeze could have on the economy than they are about the risks of inflation breaking out.

"Don't look now, but while we're in the midst of an easing cycle, the U.S. is facing a 4% inflation rate," wrote Avery Shenfeld, an economist for CIBC World Markets. "But for now, none of this matters, as both bonds and the Fed are focused on the credit crunch and its growth threat."

The economic data have been weak, but not disastrous, since October's meeting, when the Fed signaled that it thought it was done cutting rates. It's not the immediate economic situation that's brought the Fed back into the game of cutting rates, it's the horrendous condition in the credit markets, which are arguably worse off now than they were in August.

"The Fed is expected to reduce rates in response to evidence of very sluggish fourth quarter growth, and further stresses in the credit markets," wrote Brian Bethune and Nigel Gault, U.S. economist for Global Insight.

Ahead of the relatively strong employment report on Friday, markets were anticipating that the Federal Open Market Committee could cut the federal funds target rate by a half percentage point to 4%. Now it seems more likely to be a quarter-point cut, especially considering the strong minority opposition within the committee about cutting at all.

Many economists are reviving their forecast that the Fed will do something dramatic with the discount rate, a tool for providing liquidity to banks that's been underutilized in the Fed's view. The Fed could cut the discount rate by 50 basis points, further reducing the penalty spread between the federal funds rate and the discount rate to just a quarter point.