When overseas markets began to tank last Monday it provided a call to action to the Federal Reserve Bank. Fed Chief Ben Bernanke had already commented that he was prepared for bolder action to support the economy. In testimony before the Congressional budget committee on Jan. 17, Bernanke stated, “we stand ready to take substantive additional action as needed to support growth.”
But when the weakened U.S. equity markets appeared to be forcing global equities down, the situation seemed critical. With opening market calls of 400 to 500 points lower in the Dow Jones Industrial Average on Tuesday following the Martin Luther King Jr. holiday, the Fed decided that it couldn’t wait until this week’s meeting and cut the Federal Funds rate by 75 basis points. It was the largest move in recent memory and the first time since the immediate aftermath of 9/11 that the Fed adjusted that rate outside of the regularly scheduled Open Markets Committee meeting.
Reading tea leaves is a dangerous game but it wouldn’t be a stretch to think that the European weakness pushed the Fed to go with a 75 basis point cut instead of 50 basis point and do it immediately rather than wait a week for the FOMC meeting.
Those analysts pushing the Fed to be more aggressive now assume that they will come in with another 50 basis point cut at the FOMC meeting tomorrow (Jan. 30). But given recent revelations regarding European equity weakness and the recent bounce in U.S. equity indexes, that may not be a foregone conclusion.
The market rebounded strongly last Wednesday — not on the Fed’s bold action on Tuesday morning, which caused a bump before the market retreated again — but as news of the Societe Generale problems unfolded. Apparently the equity weakness in Europe at the opening of last week may have been more attributable to unwinding of fraudulent positions put on by rogue trader Jerome Kerviel than to a contagion from U.S. markets. If this is the case, then the Fed may have been hasty. And with inflation readings at his highest levels in several years (4.1% in 2007), perhaps lowering the Fed funds rate 125 basis points in an eight-day period is not the wisest of moves.
This Fed’s tendency to react to market moves is beginning to be noticed. Andrew Clare professor of finance at London’s Cass Business School and a former economist with the Bank of England asked in his weekly column, “When is an independent central bank not an independent central bank?” His answer, “Perhaps when it appears to have been bullied into action by panicking investors.”
Clare says that Bernanke is betting that as the economy weakens, inflation will as well and points out that Big Ben’s counterparts at the European Central Bank and Bank of England are not so confident inflation will moderate.
All of this makes tomorrow’s FOMC meeting outcome more interesting.
