Tuesday, October 09, 2007

A Shock to the Economic System

Today's release of the Fed's minutes from the Sept. 18 meeting gives us a better understanding of what the FOMC members were thinking when they decided to slash interest rates by 50 basis points.

For starters, the Fed "marked down" its estimate for fourth quarter GDP growth. It also "trimmed" its growth forecast for 2008. It raised its forecast for unemployment. And because business executives are growing cautious, the Fed now expects capital spending to be scaled back. Finally, the Fed trimmed expectations for both core and headline inflation.

All in all, the Fed was very concerned about the outlook for economic activity, and less concerned about inflation. The housing market deteriorated much faster and further than the Fed expected. The minutes said subprime mortgages are "essentially unavailable," that there is "little activity" in nonprime mortgages, and that borrowers of prime jumbo mortgages "faced higher rates and tighter lending standards."

But the Fed is not entirely ignoring inflation. It expressed concern about rising benefit costs and labor costs and said the weakening dollar had the potential to heighten inflation risks.

It appears that the Fed was hoping to shock the markets with a large one-time interest rate reduction. Given the strong rally in stocks ever since those cuts were made, it looks like the Fed succeeded. However, the remarks in the minutes of the Sept. 18 meeting also indicate that those who are expecting additional interest rate cuts are likely to be disappointed.