Tuesday, September 18, 2007

Okay, they cut. Now what?

As I said last night, I don't believe cutting the Fed Funds rate was a good idea. That was, and is, my opinion. It is, however, only an opinion. I could be wrong.

The Fed cut 50 basis points in both the Fed Funds and the Discount Rate. As anticipated, initial stock market reaction was very positive and the Dollar is falling against major currencies (but not by very much). The yield curve steepened, which is a good thing.

As I pointed out last night, the problems that have roiled the credit markets were less about return issues and more about risk concerns.

The cut may help financial institutions that have borrowed short and lent long (like the SIVs that were having difficulty replacing their ABCP on a cost effective basis). There will modest benefits elsewhere.

The report that I referenced last night, however, reported that teaser rate mortgages (issued at less than 2%), in particular, will be likely to default. A 50 bp reduction in the absolute rate will not do much to help those borrowers having to deal with resets.

It was concerns in the mortgage-backed securities market that initiated the market correction, and that problem still exists.

The Fed clearly is concerned about growth, and feels that inflationary pressures will not be significantly increased by this cut. I hope that they are right.

The effect on market psychology may be greater than I imagined, and THAT could make the cut worthwhile.

My only criticism of today's move is that they didn't bring the Discount Rate down to the level of the Fed Funds target. The policy of managing monetary policy through open market operations was enacted at the start of 2003. Prior to that, the Discount Rate was the primary mechanism employed by the Fed.

In my opinion, concerns about counter-party risk are unusually high in the inter-bank markets; higher than they have been since the implementation of the new policy. I believe that the Fed should have, temporarily, resumed using the Discount window as the primary mechanism so that funds would be more readily available at minimal cost.

On Wednesday we'll see the CPI numbers for August, which will give us a clearer picture of the past. Today's PPI numbers were relatively benign (2.2% increase in PPI excluding food and energy).

Bottom line, the same opportunities that were available before the cut have been unaffected.

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