The Fed's Rate-Cut Decision

Written by Stratfor


Geopolitical Diary
March 18, 2008
The U.S. Federal Reserve reduced its headline interest rates from 3 percent to 2.25 percent on Tuesday afternoon. The cut, which was a quarter point less than the consensus expectation of 1 percent, followed the Fed’s March 16 redefinition of the rules of borrowing. Nevertheless, the U.S. markets did not plummet in disappointment.

It is always difficult to understand the Fed’s reasoning. A guess would be that this actually was an attempt to instill confidence in markets. A full point cut might have been perceived as ongoing panic, while a smaller cut might have been seen as too much concern about inflation — not a trivial fear, but not good for the markets. A three-quarter point cut may have been an attempt to cut interest rates while still showing some confidence.

For the most part, the Federal Reserve prefers to ignore the financial markets along with all of the noise that is a regular feature in the world of Wall Street. It is not that there is no money or discussions of economic import occurring there — far from it — but that the Fed sees the financial markets as simply one aspect of the entire economy, and a rather erratic aspect at that. Better, goes the Fed’s thinking, to focus on the nuts and bolts of the “real” economy so that the entire thing can be kept on an even keel.

The Fed in this case is worried about the equity markets. The decline in housing prices already has taken a cut out of the net worth of individuals while hurting institutions holding mortgages of various sorts. A full-blown bear market on top of the decline in home values might have concerned the Fed more than a usual downturn would have. The double whammy of housing price declines and stock market crashes could have been devastating, even to an economy as large as the United States’. Therefore, the Fed appears to be exceedingly concerned about keeping the U.S. equity markets from tanking and is paying attention to its psychology as well as the fundamentals.

In reality, the housing correction is rather mild by historical standards, and the stock markets — only down by roughly 15-20 percent since the start of the subprime problems — are not exactly terrifying compared to previous stock crashes. But tell that to the people on Wall Street who live and breathe on the day-to-day deltas in both worlds. Their panic — and the place they occupy between the Fed, the housing market and the stock markets — is forcing the Fed to take actions that it would prefer not to.

The last time the Federal Reserve felt it necessary to enact sharp cuts when the danger to the real economy was this nebulous was during the Alan Greenspan era in the early weeks after the 9/11 attacks. Then, a cascade of rate cuts — one for a full percentage point — pared rates to the bone. In retrospect, the Federal Reserve probably overreacted. The benefit of hindsight tells us that the American recovery — not recession — began in October 2001. But the perception at the time was that the system itself might have been in danger, so there was no reason to spare the horses.

Now, as in 2001, the actual threat probably is not as bad as it seems. Now, as in 2001, the Fed’s goal is to assuage panic. But now, unlike in 2001, the panic is largely constrained to Wall Street.

That distinction provides the Federal Reserve with the opportunity to draw a line between Wall Street’s expectations and reality. The Street was expecting a rate cut of 1 percent or even more. The Fed ultimately gave up “only” three-quarters of a percent. The subtext is that the Fed is not as concerned as the Street about what is going on out there. It is a subtle difference, but one that is required to prevent the likes of Enron from being more than a footnote in American corporate history.

SOURCE: Stratfor

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