The Fed’s Halloween Cut – Trick or Treat?

The Fed gave markets a treat by cutting rates by 0.25% yesterday, taking rates to 4.5%. The nasty trick, though, was that the Fed said that the upside risks to inflation balances the downside risks to growth. Monetary policy is ‘neutral’, ie there is (supposedly) an equal chance of the next rate move being upwards as downwards. I say ‘supposedly’, because yesterday’s Fed cut coincided with the Fed pumpkining $41bn of liquidity into the banking system, the biggest single day of such injections since September 2001.

My job is to try to work out what ‘neutral’ and ‘balanced’ actually means. Do we have a perfectly balanced economy with minor inflationary and growth challenges? Or do we have a monster of a problem, with the threat of a severe US recession (led by the housing market), coupled with equally severe inflationary pressures (brought on by skyrocketing commodity prices and a collapsing dollar)? If the former, then one can relax for the next six months; but my fear is it is the latter and stressful times lie ahead.

The Fed has twin objectives of targeting ‘core’ inflation and supporting the economy, but if push comes to shove it will not let the inflation genie out of the bottle. After all, the Fed earned its reputation under Paul Volcker by killing inflation in the early 1980s. I think the Fed would be prepared to risk recession. 2008 could be a horror show.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Richard Woolnough

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