Well, the deed is done, and the markets are moving. Instead of muddling in the middle with a 25 basis point decrease in the Fed funds rate, the Fed apparently decided to go all out Tuesday with a 50 basis point cut to 4.75% in an attempt to forestall further economic weakness and a recession.
Everybody had pretty much accepted at least a 25 bp hike, so that wouldn’t have been very market moving. Stocks obviously loved the 50 bp news, sending the S&P 500 above the 1500 level again for the first time since the skid that started in July, and currencies such as the euro soared immediately after the announcement. It also seems to be good news for beleaguered home owners facing higher mortgages payments.
But was the larger decrease, the first 50 bp decrease in the Fed funds rate in nearly five years, a wise move? More bad news on the housing, construction, jobs, etc. front is almost certainly forthcoming, but the economy seems to be absorbing the early shocks from the sub-prime mortgage and hedge fund debacles and is, albeit more slowly, plodding along. Instead of waiting to see more data about how things are progressing after the mid-year slump, the Fed now has a little less flexibility to react at its next meeting Oct. 30-31 in case its larger cut doesn’t have the positive effect it wants (although it still has room to bring the discount rate down further).
The main casualty in all of this is likely to be the U.S. dollar, which has been teetering on the brink of sliding to new lows and is now almost certain to head for new lows. There is evidence from past episodes of declining Fed funds rates that the U.S. dollar could surprise everyone and gain strength, based on the assumption that the rate increase and its impact on the dollar was already in the market. But whether that will happen this time remains to be seen with the dollar at its current lowly position.
The prices of commodities such as oil and the metals jumped along with the foreign currencies after the announcement. Other markets such as grain and soybean futures had just ended their regular trading sessions for the day when the Fed released its statement, and it will be interesting to see how they respond. With presumably more pressure on the dollar, prices of all markets priced in dollars seem likely to head higher.
Higher prices brings up that “I” word again – inflation – that the Fed has been fighting for months. The Fed is always walking a fine line between inflation-recession, but how will it respond when that “I” monster becomes an issue again?