Tuesday, December 11, 2007

Ominous Warnings From the Fed

Today's Fed statement was filled with ominous warnings. It made references to slowing economic growth, the housing correction, softer business and consumer spending, strains in financial markets, elevated energy and commodity prices, inflation risks, and increased uncertainty. In other words, there is no good news to report.

Although the Fed cut the fed funds rate and the discount rate by a quarter point each, the market was strongly disappointed. Many investors were hoping for bolder action, perhaps a half-point cut in both rates. At the very least, investors were expecting more clarity from the statement. They exhibited their disappointment by selling stocks. Almost immediately, the Dow shed more than 200 points.

The Fed's comments make it clear that the probability of recession is much higher than many economists (including those at the Fed) had been forecasting. Yet with higher food prices, and with oil prices still flirting with the $90 per barrel level, the Fed knows it cannot focus solely on core inflation numbers anymore. The Fed knows that high food and energy prices will inevitably work their way into the core figures.

The Fed is truly between a rock and a hard place, officiating a game of tug-of-war between slowing growth and inflation. My view is that the Fed did the right thing by cutting the fed funds rate by just a quarter point. A steeper cut would have contributed to the dollar's weakness. However, I believe the Fed could have been a more aggressive with the discount rate. Given the slowing economy and the real potential for recession, there is no need to keep the discount rate a half-point above the fed funds rate.