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The Federal Reserve under delivers.  The futures market was pricing in a 100bp rate cut but they cut the Fed funds and discount rates by only 75bp.  Even though the US dollar has rallied on the heels of the announcement, don’t expect this strength to last because the Federal Reserve is playing a dangerous game.  With a statement packed with concern about the outlook for the US economy, they are simply delaying the inevitable.  What was even more surprising was that two members of the Federal Reserve actually voted for a smaller rate cut. 

They should have cut interest rates by 100bp but they feel that they have done a lot over the past few days and want to leave the door open for an intermeeting rate cut in case there is another disaster in the banking sector.   Inflation is also a problem which could have contributed to their decision to cut less, but the bottom line is that economic activity has and will probably weaken further due to tighter credit conditions and a deteriorating housing market. 

The US dollar is now the second lowest yielding currency in the developed world thanks to the Federal Reserve’s 75bp rate cut.  At this point, the Japanese Yen is the only currency that yields less than the US dollar.   If the US economy does not recover or liquidity problems do not ease, we still believe that the Federal Reserve could drop interest rates to 1 percent, which would come close to matching Japan’s levels. 

Since the last Federal Reserve meeting, the US economy has deteriorated significantly, the US dollar has fallen to record lows, the banking sector is a mess and the fear of counterparty risk has frozen liquidity.  This has forced the Federal Reserve to work overtime with new measures announced on a near daily basis.  Since February, they:

1.       Cut interest rates to 2.25 percent

2.       Brought the discount rate down to 2.50 percent

3.       Opened up their lending facility to primary dealers (or investment banks)

4.       Announced that they will be auctioning up to $200 billion

5.       Expanded the collateral that they are willing to take to investment grade debt securities

And, this doesn’t even count the bailout of Bear Stearns or their agreement with JPMorgan Chase to take on $30 billion worth of Bear’s less liquid assets. 

With the fear of counterparty risk possibility causing liquidity problems for other banks on Wall Street, the Federal Reserve is still on high alert.   Despite the historic move, they will not be able to sit back and relax just because they stepped up monetary easing.  In fact, the futures market is pricing in further rate cuts and creativity is vital if the central bank wants to prevent the US from turning into Japan.  In the 1990s, Japan fell into 10 years of stagnation after a similarly severe banking crisis.  

We expect the US dollar to continue to fall because the band-aids are just not enough – and if anything, this band-aid is way too small.   Don't expect the stock market to take this favorably either because  this morning's 300 point rally was on the hope that the Fed would cut by at least 100bp.

Comparing the FOMC statements **New Language Highlighted

January 30, 2008 

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 3 percent.

Financial markets remain under considerable stress, and credit has tightened further for some businesses and households.  Moreover, recent information indicates a deepening of the housing contraction as well as some softening in labor markets.

The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.

Today’s policy action, combined with those taken earlier, should help to promote moderate growth over time and to mitigate the risks to economic activity.  However, downside risks to growth remain.  The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.  Voting against was Richard W. Fisher, who preferred no change in the target for the federal funds rate at this meeting.

By Kathy Lien, Chief Strategist of DailyFX.com