Will the Fed Cut Rates?

[flow5]

The transactions concept of money velocity (Vt) has its roots in Irving Fischer’s equation of exchange (PT = MV), where (1) M equals the volume of means-of-payment money; (2) V, the rate of turnover of this money; (3) T, the volume of transactions units. The “econometric” people don’t like the equation because it is impossible to calculate P and T. Presumably therefore the equation lacks validity. Actually the equation is a truism – to sell 100 bushels of wheat (T) at $4 a bushel (P) requires the exchange of $400 (M) once (V), or $200 twice, etc.

The real impact of monetary demand on the prices of goods and serves requires the analysis of “monetary flows”, and the only valid velocity figure in calculating monetary flows is Vt. Income velocity (Vi) is a contrived figure (Vi = Nominal GDP/M). The product of MVI is obviously nominal GDP. So where does that leave us? In an economic sea without a rudder or an anchor. A rise in nominal GDP can be the result of (1) an increased rate of monetary flows (MVt) (which by definition the Keynesians have excluded from their analysis), (2) an increase in real GDP, (3) an increasing number of housewives selling their labor in the marketplace, etc. The income velocity approach obviously provides no tool by which we can dissect and explain the inflation process.

To the Keynesians, aggregate demand is nominal GDP, the demand for serves (human) and final goods. This concept excludes the common sense conclusion that the inflation process begins at the beginning (with raw material prices and processing costs at all stages of production) and continues through to the end.

Admittedly the data for Vt are flowed. So are nearly all economic statistics, but that does not preclude us from using them. An educated estimate is better than no estimate at all. For example, we know that the international balance of payments balances – debits equal credits, payments equal receipts, etc. The Department of Commerce statistics do not prove this, so in order to make their statistics balance, they put in an “errors and omission “balance figure. The triumph of good theory over inadequate facts.

The Fed first calculated deposit turnover in 1919. It reported weekly until 1941. The figure “other banks’’ was used until 1996. Prior to this revision Vt included all banks located in 232 SMSA’s excluding N.Y. City. This was the best that could be done to eliminate the influence on prices of purely financial and speculative transactions. Obviously funds used for short selling do not contribute to a rise in prices. The Fed calculated these velocity figures by dividing the aggregate volume of debits of these banks against their demand deposits. Like M3, the series was also discontinued, in Oct. 1996.

In calculating the flow of funds (MVt), I am assuming that the Vt figure calculated by the Fed is not only representative all commercial banks in the United States, but that the velocity of currency is the same as for demand deposits. Is this valid? Nobody knows.

But we do know that to ignore the aggregate effect of money flows on prices is to ignore the inflation process. And to dismiss the concept of Vt by saying it is meaningless (that people can only spend their income once) is to ignore the fact that Vt is a function of three factors: (1) the number of transactions; (2) the prices of goods and services; (3) the volume of M.

Inflation analysis cannot be limited to the volume of wages and salaries spent. To do so is to overlook the principal "engine" of inflation - which is of course, the volume of credit (new money) created by the Reserve and the commercial banks, plus the expenditure rate (velocity) of these funds. Also overlooked is the effect of the expenditure of the savings of the non-bank public on prices. The (MVt) figure encompasses the total effect of all these money flows.

It's mathematically impossible to miss an economic forecast.

[economist]

Saw an article on yahoo news that also talked about how the Fed would cut on Sept. 18 and now this article as well in Fortune magazine.
Like it or not, the market players are expecting a cut and if the Fed does not cut, it will send the American stock market, consumer, etc. in to a horrific nose dive and if there is a recession people will start blaming the Fed for it.
My stand by my view that the Fed will have to cut on Sept. 18: you see even though inflation does not seem to be fully tamed and commodity prices are rising, the situation is nowhere as dire to the one seen in the 1970s oil price shock, or other inflationary periods.....in the end an organization like the Fed has to be ready to strike compromises......indeed in the current situation and climate in the US, there might be a too heavy price to pay by staying pat and so they will go for it.

http://money.cnn.com/2007/09/13/news...view/index.htm

The Fed's unkindest cut?
Wall St. is certain the Fed will cut rates to ease the pain of the credit crunch. But how will investors react if Bernanke & Co. cut by just a quarter of a point?By Paul R. La Monica, CNNMoney.com editor at large
September 14 2007: 1:07 PM EDT


NEW YORK (CNNMoney.com) -- The Federal Reserve is going to cut the target on a key short-term interest rate on September 18. There is no mystery about that.

According to futures on the Chicago Board of Trade, the market is pricing in a 100 percent chance of a cut to the federal funds rate, an overnight bank lending rate that heavily impacts how much interest consumers pay on their credit card debt, home equity lines of credit and car loans.

The fact that the Fed already cut its discount rate, which is what banks pay to borrow money from the central bank, in a surprise move on August 17, coupled with remarks from Fed members in the past few weeks about how closely they are monitoring the mortgage meltdown that is roiling the markets, makes it a virtual lock that Ben Bernanke and Co. will lower the fed funds rate on Tuesday.

Fed can't stop recession
Still, there is a fair amount of intrigue surrounding the September 18 meeting. Specifically, investors are unsure about how much the Fed will lower interest rates.

The Fed cut the discount rate by a half of a percentage point, from 6.25 percent to 5.75 percent, on August 17, leading many market observers to speculate that the Fed would also lower the fed funds rate by a half of a percentage point on September 18.

To that end, as of September 14, investors were factoring in a 58 percent chance that the Fed will cut the fed funds rate by 50 basis points, or half of a percentage point, to 4.75 percent, on Tuesday.

But hopes appear to be diminishing somewhat for a big rate cut. Investors had been pricing in a 74 percent chance of a 50 basis point rate cut on September 12.

Still, what will happen if the central bank only lowers interest rates by a quarter of a percentage point? Fed watchers said it all depends on what the Fed says in its statement.

John Norris, director of wealth management at Oakworth Capital Bank, a private bank in Birmingham, Ala., said the market would probably not be too happy with just a 25 basis point cut at first. But he thinks that in some ways, a smaller rate cut might be more reassuring.

"Obviously everyone wants a 50 basis point cut. If it's only a quarter of a point the market will be upset," Norris said. "But if the Fed cuts by 25 basis points and the language in the statement is strong enough to indicate that this is the first of many cuts to come, cooler heads will prevail. Investors would like that as much, if not more, than a half-point cut with language that indicates this is just a one-off thing to placate the markets."

Why the credit crunch may deepen
Scott Martin, managing director with Astor Asset Management, a Chicago-based investment firm with $200 million in assets under management, agreed that a half of a point cut might soothe the market at first...but not for long.

"If the Fed cuts by 50 basis points, you have to worry about the health of the economy. If the Fed can just say that they are going to keep an eye on the subprime market and signal that they may cut two more times by the end of the year, that might be the best case scenario," Martin said.

Vincent Boberski, portfolio strategist with FTN Financial in Memphis, also said that a half-point cut might get some cheers at first but it could wind up spooking the markets once investors realize the reason behind it.

"If the Fed were to cut rates by a half point, it might backfire since it could potentially give the market the impression that the economy is much weaker than investors thought," Boberski said.

Despite fears that the subprime mortgage market implosion could send the economy into a recession, fears stoked by the surprise decline in jobs during the month of August and a smaller-than-expected increase in retail sales, Norris points to other economic evidence that might prevent the Fed from cutting rates aggressively.

For one, oil prices hit $80 a barrel for the first time ever on Wednesday. That, as well as rising prices for other commodities, could keep the Fed from lowering rates by too much since it wants to keep inflation in check.

Tales of the crash of 2007
Norris added that the most recent figures from the Institute of Supply Management regarding manufacturing growth and services industry growth indicate that the economy is still expanding.

"Bernanke is in an awkward situation. Right now, the data is still mixed. And he doesn't want his reputation to be that financial markets are dictating monetary policy. He doesn't want to be known as the Fed chairman that was bullied around by Wall Street," Norris said.

David Joy, chief market strategist with RiverSource Investments, a Minneapolis-based asset management firm agreed, adding that the economy still does not appear to be in dire enough shape to justify a half-point cut.

"If the Fed cuts rates by a quarter of a point, you will hear howls from those who think the Fed is behind the curve," Joy said. "But in my mind, a quarter of a point cut is appropriate. I'm not sure the economy needs a half-point cut. Plus, the Fed could always lower rates further in the coming months."

Compounding matters though is that Bernanke's widely respected predecessor, Alan Greenspan, is currently making comments about the economy as he promotes his new memoir, which will be published on Monday.

That has led some on Wall Street to unfavorably compare how Bernanke is handling the subprime woes with how Greenspan dealt with numerous crises during his tenure, such as the 1987 Black Monday crash, the collapse of the hedge fund Long-Term Capital Management in 1998 and the September 11 terrorist attacks.

But according to excerpts released Thursday from an interview that will air on the CBS news show "60 Minutes" Sunday, Greenspan said that he felt criticism of Bernanke was unfair and added that his successor was doing "an excellent job."

Still, Greenspan's legacy has come into question lately as well. According to the excerpt from the "60 Minutes" interview, Greenspan admitted that the Fed did not fully grasp how much of a danger the explosion in demand for subprime mortgages would have on the economy.

Martin of Astor Asset Management pointed out that Bernanke might want to avoid cutting interest rates too drastically, since it can be argued that the historically low rates from earlier this decade helped bring about the subprime mess in the first place.

"The market is begging for a rate cut but we're trying to fix a liquidity problem with more liquidity. It's kind of funny," Martin said.

So while a half-point rate cut might be considered a quick cure for what's ailing Wall Street, some think it might be more pragmatic for the Fed to lower rates gradually.

"It would be a bold move to cut rates by a half of a point," Boberski said. "There is some justification for it since the labor markets are a lot weaker than people thought. But it seems like the Fed would prefer to take an incremental approach since Bernanke does not want to be seen as bailing out the financial system."

Joy added that it's amusing to see people criticize the Fed for not cutting rates since many Fed skeptics thought the central bank kept rates too low for too long.

"It's somewhat disingenuous to say the Fed needs to cut rates to bail out housing while at the same time many of these people were saying a year ago that the Fed needed to raise interest rates because the housing market was a bubble," he said.

To that end, Boberski thinks the Fed would rather cut rates two or three times by a quarter of a point before the end of the year and perhaps once or twice more in 2008.

[Antonio Sousa]

Interest rate expectations have clearly changed in the last few days.

Now, a majority of traders are expecting a 50 basis point rate, not 25 bps, when the FED announces its interest rate decision tomorrow at 2:15 PM trough the FOMC.

How to trade this idea?

I assume the US dollar will rally if the FED doesn't meet the 50 bps rate cut expectations and I'll be long US dollars against the Japanese yen starting tomorrow at 2:30.

Long USDJPY @ market (09/18 14:30)
Profit Target @ 120.00
Stop Loss below 110.00

[Terri Belkas]

I'm really looking forward to seeing how the stock markets react, as it could play a big role in how forex carry trades respond to the news. Once everything is said and done and we look at the markets on Friday, I think that if the Fed only goes through with a 25bp cut, we'll find a somewhat muted reaction and forex carry trades will likely gain slightly. There's no doubt that we'll see substantial volatility tomorrow afternoon, but I think major shifts in price action will only come as the result of a 50bp cut or no cut at all.

[DailyFX Analyst]

Here is my call before the event.

Fed lowers 25bp
Possibly lowers discount rate

States that economy remains robust despite slowdown in housing.
Address upside risk to prices and

Does NOT make any reference to future cuts.

[Terri Belkas]

Originally Posted by Antonio Sousa Interest rate expectations have clearly changed in the last few days. Now, a majority of traders are expecting a 50 basis point rate, not 25 bps, when the FED announces its interest rate decision tomorrow at 2:15 PM trough the FOMC.

As Antonio mentioned, the probabilities of a 50bp cut are greater than that of a 25bp cut. On the other hand, compared to September 12th, the percentage of economists polled by Bloomberg expecting a 25bp cut has jumped to 78 percent from 69 percent, while only 18 percent expect a 50bp cut, down from 21 percent last week. It will be interesting to see who will be proved correct: the markets or economists?

[David Rodriguez]

Originally Posted by Terri Belkas As Antonio mentioned, the probabilities of a 50bp cut are greater than that of a 25bp cut. On the other hand, compared to September 12th, the percentage of economists polled by Bloomberg expecting a 25bp cut has jumped to 78 percent from 69 percent, while only 18 percent expect a 50bp cut, down from 21 percent last week. It will be interesting to see who will be proved correct: the markets or economists?

The economists are usually far more conservative than actual market pricing tools. Why might this be?

It's a lot easier to side with the majority if there's a dominant view that is much more likely to occur. In other words, the binary 25/50 cut prediction will fall much more towards 25 than the seemingly less likely 50bp cut.

Me personally? I think it's virtually a coin flip. I've heard compelling arguments for and against 50bp in rate cuts. The 25bp cut is a done deal, since the Effective Fed Funds rate has held at or below 5.00 percent through recent price action. As for 50? Well, we'll just have to wait and see.

[Ivanovich]

Here's a question for you historical stat gurus:

Has there ever been a time where the Fed has NOT moved (held steady) while the Fed Futures showed 100% probability of a cut?

[David Rodriguez]

Originally Posted by Ivanovich Here's a question for you historical stat gurus: Has there ever been a time where the Fed has NOT moved (held steady) while the Fed Futures showed 100% probability of a cut?

A quick (admittedly superficial) look at the Fed Funds rate and relevant futures shows that there have been very few instances in which the futures are unable to accurately predict the next move. Very notable exceptions to the rule occurred in late 1999, early 2000, where markets didn't expect the Fed to take rates higher.

Markets similarly didn't expect the Fed to cut by 50 in 2001, but since then speculators have been really good at handicapping the Fed's next move.

So to answer your question: the market is very infrequently wrong. But 'incorrect guesses' are much more likely to occur near significant shifts in monetary policy stance.

i.e. situations similar to what we face currently.

[Ivanovich]

Excellent chart and data. But the question (and this might be impossible to figure out) was whether there was a time in which the Fed futures showed a 100% chance of a move (either cut or hike) and no move actually occured?

[flow5]

Next to William McChesney Martin, Bernanke is of the next highest caliber. Bernanke is not only a scholar, but he has common sense. He should be given a lifetime post at the FED.

The FOMC's correct position & probably Bernanke's position, is to side step a rate cut. The FED's primary concern is with inflation and they're not getting any cooperation from fiscal policy, our current-account deficit, nor our foreign unilateral transfers (the Pentagon).

The current-account deficits are inexorable forcing the dollar down in terms of its foreign exchange value—and no consortium of central bankers, treasury secretaries, et al., can stop the process.

With a chronically depreciating dollar foreigners will be much less inclined to invest in the U.S. on a creditorship basis, thus pushing up interest rates. The rising cost and diminishing volume of imports will contribute to an increase in inflation, and the expectation of further inflation will also push up interest rates. This spells stagflation.

Unless we are willing to make those fundamental reforms requisite to successfully competing in international markets, the continued decline of the dollar will finally force a payments balance on us. Under these circumstances, we can expect long term deterioration in the standard of living of the vast majority of the people in this country

Let there be collateral damage.

[Euchre]

Yes they will - the discount rate by 50-75 basis points. There already is a soft "implied" reduction the fed funds rate currently trading under 5%.

My sense is if they do cut fed funds by 25 bps then discount goes 75 bps to match it. This issue will best be solved by discount rate cuts not by fed funds. Sub primes, tight credit on commercial paper , etc is a bank issue and credit issue. I dont see how dropping the discount rate would really help as the delay is 6 + months.


fwiw

Euchre

Disclaimer Trading Currencies involves risk. Any opinion, research, analyses, prices, or other information is provided as general market commentary, and does not constitute investment advice.

[FXpert]

Originally Posted by flow5 Inflation analysis cannot be limited to the volume of wages and salaries spent. To do so is to overlook the principal "engine" of inflation - which is of course, the volume of credit (new money) created by the Reserve and the commercial banks, plus the expenditure rate (velocity) of these funds.

So what you are saying, in short, is that it really doesn't matter what the fed does, because liquidity has already dried up. The only thing the fed can do is make it so unappealing to hold cash that the big players can't stomach holding cash. But wait, why hold dollars when you can make a far better yield in the Viking currencies? A significant rate cut will tie up US capital in foreign assets, and a rate hike will cause cash markets to lock-up again. Either way, a change means the US is driving over a cliff.

So what's the FED's only option? Do nothing!!! The economy is fine. A 25bp cut does not count as a cut because its insignificant.

Banks have the 3-6-3 rule, the Fed should have a 5-5-5 rule, 5% overnight, 5% unemployment, and home at 5PM.

[FXpert]

Originally Posted by Terri Belkas As Antonio mentioned, the probabilities of a 50bp cut are greater than that of a 25bp cut. On the other hand, compared to September 12th, the percentage of economists polled by Bloomberg expecting a 25bp cut has jumped to 78 percent from 69 percent, while only 18 percent expect a 50bp cut, down from 21 percent last week. It will be interesting to see who will be proved correct: the markets or economists?

Two points, first I'd like to see the methodology Bloomberg uses for those probabilities. Second, that data is futures data, meaning its wildly skewed by hedgers. The binary option data is likely to be the most accurate, as no one uses binary options to hedge, except maybe the odd options market maker short vega and needing a touch option to flatten the book, meaning you can see unfiltered market bets based on sound econometrics. What is the binary data showing???

[RISKEE]

The Fed's are forced to let go of the 5.25bp and reconsider to either 25bp or even 50bp , But wouldn't go for the latter , as Even that we know US economy is in one of its major slowdowns , yet GREENSPAN says " Rates Shouldn't be Cut , as the US Economy is in STALL " , well greenspan has definately a way of telling how the fed's may think , in my opinion , the Feds will go for 25bp cut , to see how the upcoming months will form in housing , labor market and consumer spending , So a STEPLADDER strategy would be considered.