What Does the Fed Decision Mean for Financial Markets?

[DailyFx]

Weekly Bank Research Center 9-24-07






Reflation, Inflation or Dollar Flight?



Stephen Roach, Head Economist, Morgan Stanley

Financial markets both celebrated and panned the Fed?s easing of monetary policy this week. Risky assets rejoiced and posted stunning rallies as stress in money markets ebbed. Reading the Fed?s half-point move as reflationary, global equities have rallied anywhere from 2.7% in the US to 4-5% in overseas markets. Credit spreads, measured by the Series 8 investment-grade CDS index, tightened by 13 bp. Money-market stress eased considerably, with one-month LIBOR and asset-backed commercial paper rates falling by more than the 50 bp decline in the Federal funds rate and 100 bp from their recent peaks.
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FX Forecast Update: EURUSD to 1.38 in One Month



Niels-Henrik Bjørn Sørensen, Senior Analyst, Danske Bank

On Tuesday, FOMC surprised the markets by reducing the Federal funds rate by 50bp. By contrast, the mar-kets. central expectation was for a 25bp cut. At first glance, the initial market reaction of lower interest rates across the maturity spectrum appears reason-able. FOMC communication ahead of the meeting had revealed a variety of views among FOMC members and market jitters no longer intensified. Consequently, the unanimous decision (all 10 voting FOMC members voted for a 50bp cut) gave the impression that the FOMC suddenly had become more worried about the economic outlook. However, once the markets had digested the decision, and the statement in particular, a counter-directional steepener emerged, where short rates were lower but longer rates were higher. The FOMC statement indi-cated that the rate reduction was motivated by fears of an economic slowdown, induced by the housing market and disruptions in financial markets. At the same time, the FOMC maintained that inflation risks remain on their radar screen. Easing monetary policy in the face of inflationary pressures is not usually associated with the reaction pattern of a credible central bank. It could be argued that the FOMC has effectively demonstrated that it attaches relatively more weight to economic growth than to inflation. In light of this, it is not surpris-ing to see market-based inflation expectations edge up. After all, import prices, food prices, unit labour costs and commodity prices are on the rise.

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Fed rides to the rescue


Steve Chan, Economist, TD Bank Financial Group

The Federal Reserve slashed its federal funds rate - the first cut in over 4 years, in a bid to calm mounting concerns over the depth of a crisis in the U.S. mortgage market. The financial turbulence and the on-going weakness in the U.S. housing market have increased the downside risks to growth. In particular, high housing inventory levels, along with declining sales, will likely push down prices and depress home equity values through 2008. On the inflation front, there have been signs that pressures are ebbing. Core CPI growth has fallen from a cyclical high of 2.9% in September to 2.1% in August. And with home prices and rents likely to slow further amid the trauma in the housing markets, core inflation should remain around the 2% level. Moreover, softening labour market should cap wage pressures.

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