NEWS / Foreign Exchange

The Economy after September 18

The Economy after September 18

The Fed is widely expected to lower the federal funds rate 25 basis points to 4.50% on October 31. On September 18, the Fed cut both the federal funds rate and the discount 50 bps to 4.75% and 5.25%, respectively.

Money and credit market spreads have narrowed considerably, with the spread between 3-month Libor and 3-Treasury bill at 110 basis points, down from 168 basis points on September 18; the spread between 3-month commercial paper and 3-month Treasury bill has declined to 85 basis points from 168 basis points on September 18. At the long end, the improvement is less encouraging. The spread between the Merrill Lynch junk bond yield and 10-U.S. Treasury note yield at 434 basis points versus a high of 471 basis points on September 10 has been the least responsive segment. The Fed??™s performance score on this aspect is a B+.

The Fed noted that the September 18 action "was to forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth overtime." Given the time lags in the impact of monetary policy changes on the economy, evidence of the benefits pertaining to economic growth from the cut in the federal funds rate will not be visible immediately, with the exception of benefits on the functioning of markets which is visible from a narrowing of spreads.

Information from the housing market is largely gloomy. Combined sales of existing and new single-family homes declined 23.5% in September on a year-to-year basis and it takes about 10.3 months to sell an existing or new single-family home. The median price of an existing single-family home fell 4.9% on a year-to-year basis in September, the largest drop since 1968, when record keeping began. On a year-to-year basis, sales of new single-family homes fell 25% from a year ago. The Housing Affordability Index shows a small improvement (114.6 in September vs. 103.6 in July) but home sales remain weak. The homeownership rate has now recorded the longest string of quarterly declines since 1980. The impact of the September 18 action and likely future cuts in the federal funds rate will be seen only several quarters ahead.

In the labor market, initial jobless claims are holding at levels around 330,000. Payroll employment averaged 97,000 during the three-months ended September, down from an 134,000 average monthly increase in the first six months of the year and a 189,000 average in all of 2006. The labor market is a sector whose problems started before the housing market crisis.

The GDP report for the third quarter will be published prior to the FOMC policy announcement on October 31. The consensus forecast is a 3.0% increase compared with our forecast of 2.0% increase in real GDP during the third quarter. In any case, the success of Fed policy will be judged on how painlessly a soft landing can be achieved without an irrational restraint in spending which calls for aggressive policy moves.

The weak dollar is the major roadblock that prevents the Fed from addressing the likely weakness in business activity per se. The trade weighted dollar is trading at a record low of 73.3 (see chart 1). Core inflation has shown noticeable moderation and the August personal consumption expenditure price index excluding food and energy (1.76% yoy change) is below the Fed??™s comfort zone. But, the weak dollar and its inflationary implications prevent the Fed from declaring that all is on safe on the inflation front. How the FOMC chooses to handle this is the tricky part of monetary policy discussions on Halloween Day. Markets could be nervous if the Fed fails to deliver the expected treat of a cut in the federal funds rate.