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The long-anticipated rate cut.


Fig 1,2, 5, 6, 3, 4, The Federal Open Market Committee voted unanimously today to lower the fed funds target 50 basis points to 4.75 percent. This was the first rate cut since June 2003. In a related action, the Board of Governors approved a 50 basis point reduction in the Primary Credit rate to 5.25 percent. This action followed a 50 basis point reduction on August 17.

The Committee's statement emphasized that "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." Recognizing that readings on core inflation had improved modestly this year, the FOMC noted, however, "that some inflation risks remain, and it will continue to monitor inflation developments carefully."

Although the prices of futures and options on fed funds suggested that market participants expected a rate cut, opinion was somewhat divided between a 25 basis point cut and a 50 basis point cut. In any case, equity markets welcomed the Committee's choice. Broad market indexes jumped almost three percentage points after the policy announcement.

The period since the August 7 FOMC meeting has been eventful to say the least. Within days of that meeting, it had become evident that the default rate on subprime mortgages was much higher than had been anticipated. Furthermore, it was rapidly becoming clear that the effects of the jump in foreclosures were spilling over into other markets, generating a substantial and rather sudden increase in financial market volatility. The market turmoil caused many lenders to back away from markets, putting a strain on banks, which had established backup credit arrangements with the stranded borrowers. The strain on the banking system to provide the full amount of credit came into question.


It was but three days from that meeting that the Board of Governors responded to assuage market concerns in a press release. The August 10 statement said:

"The Federal Reserve will provide reserves as necessary through open market operations to promote trading in the federal funds market at rates close to the Federal Open Market Committee's target rate of 5 1/4 percent. In current circumstances, depository institutions may experience unusual funding needs because of dislocations in money and credit markets. As always, the discount window is available as a source of funding."

The announcement fueled expectations that the FOMC would follow with a sequence of reductions in the fed funds target. Indeed, implied yields on prices of fed funds futures suggested that some market participants believed that an inter-meeting rate cut was possible in August.

The FOMC did not change rates before today's meeting, but it met on August 17 and issued a statement, which was released in conjunction with one from the Board of Governors announcing that it had voted to decrease the primary credit rate at the Reserve Banks from 6 1/4 percent to 5 3/4 percent, effective immediately. The FOMC's statement read:

Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.

Such an intermeeting statement is very unusual, but it reflected the unusual nature of the circumstances. The FOMC had found little evidence that financial turmoil had yet substantively affected economic activity. Thus, the statement sought to reassure markets that it would act promptly to cut the funds rate if it were to see adverse effects on the economy.


The announcement generally reinforced a shift in market participants' beliefs about the future path of policy. A rate cut by September at this point seemed likely. The question was whether it would be a 25 basis point cut or a 50 basis point cut. The odds of the more dramatic action increased sharply when a weak employment report offered some evidence that the economy was being adversely affected.

Although the FOMC did not officially vote to reduce fed funds rate during the intermeeting period, the effort to supply sufficient reserves resulted in an average daily fed funds rate well below the target rate. The rate traded closer to the target in the past few weeks, however, as markets seemed to calm. Indeed, term lending rates for loans among banks in Europe tended to stabilize if not recede. For example, the one-month London Interbank rate (Libor) has declined over the past week.
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Title Annotation:Money, Financial Markets, and Monetary Policy
Author:Carlson, John B.; Shenk, Michael
Publication:Economic Trends
Date:Sep 1, 2007
Previous Article:July price statistics.
Next Article:What is the yield curve telling us?

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