The Federal Funds Rate Cut and Reaction
By: Matt Koppenheffer for Smart401k.com
Having already discussed what the Federal Reserve and Federal Open Markets Committee (FOMC) are and what they do, let’s take a look back at what the FOMC did this week and what it means for the financial markets.
The Federal Reserve’s Take
In short, the FOMC decided to cut its Federal Funds Rate target 50 basis points (0.5%) from 5.25% to 4.75%. Not only is it significant that the FOMC cut rates, but the size of the cut is also meaningful. But first, let’s take the FOMC’s statement in parts (the text of the FOMC’s statement will appear in italics).
Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today’s action is intended to help 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 over time.
If you’re anything like me, when you start feeling sick, you don’t wait for a full-blown flu to set in before you start guzzling water and upping your vitamin C intake. In other words, you try to head off the sickness before things get too bad.
This is exactly what the FOMC has said here. Economic growth was still OK through the beginning of the year, but they saw the potential of tight credit markets (a fever) to intensify the housing correction (bad chest congestion). They hope that a rate cut (a lozenge) will help ease the situation enough that the housing correction can take place without causing a recession.
Readings on core inflation have improved modestly this year. However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.
As I discussed in the overview of the FOMC, when the FOMC lowers its targeted Federal Funds Rate, it buys government securities in the open market to pump more money into the system. A potential side effect of this action is an increase in inflation, as measured by indexes of consumer and business prices that the Fed watches. Here, the FOMC is asserting that so far this year inflation has been kept under control, and so there is not an imminent worry of prices getting out of control.
Developments in financial markets since the Committee’s last regular meeting have increased the uncertainty surrounding the economic outlook. The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.
The final paragraph of the release more or less reiterates what the FOMC’s stance is and underscores the fact that it is ready to do more should the situation continue to deteriorate.
The Market’s Take
Though there was a reasonable-sized minority of market participants that were expecting a 50 basis point rate cut, the majority of the market was taken by surprise. Some people were expecting the Fed to continue to hold rates steady at 5.25%, while many others saw a 25 basis point cut — the typical “moderate” move for the Fed — as the most likely move.
The larger than expected rate cut was very well received by the market, as measured by the one day rise of nearly 3% in the S&P 500 index, and similar gains in the Nasdaq and the Dow. The reason for the jubilant reaction is that many believe the lower rates will do exactly what the FOMC said in its statement and ward off further economic disturbances. Some may even see this as a near-term solution to the trouble in the housing market.
But the rate cut was not without controversy. While many saw good logic in the Fed’s move, many others believed that the decision to cut rates created a “moral hazard” and would encourage speculators to take increasingly larger risks with the thought that the Fed would bail them out if things went poorly. On the extreme side of this argument are those that believe if anything the FOMC should have raised its target rate to further shake out the speculators.
The Long Term Investor
As a long term investor, the rate cut may be interesting to follow, but it should not have a major impact on your continued, steady investing. The last time the FOMC went from raising rates to cutting them was in 2001 when the Internet bubble was bursting. However, this does not necessarily mean that the markets are headed for a major tumble similar to then — in the mid and late 90’s the Fed also cut rates a few times, and that was in the middle of one of the greatest bull markets one could hope to see.
The worst case scenario for the long term investor would be for the Fed to take an extreme tactic of either cutting rates to the point where inflation became a major problem, or raising rates to the point where deflation actually became a risk. The ideal for us is for the Fed to take a cautious and measured approach to the situation that will steady the economy while keeping it on a sustainable long term growth path.
