Federal Reserve versus the Market: Who is Right?

The story of the day is not the US dollar but rather carry trades, which are up sharply on the back of the strength in the stock market. News that Citigroup received a $7.5 billion cash infusion from the Abu Dhabi Investment Authority has sent financial shares skyrocketing on the hope that the cash infusion will stabilize the banking giant that announced another round of job cuts on Monday.

Unfortunately economic data indicates that even if this will help Citigroup, the US economy is not out of the woods. Consumer confidence fell to the lowest level since the series began in October 2005, following the destruction of Hurricane Katrina. With oil prices and adjustable rate mortgage payments rising, the consumer is really feeling the pinch of higher living costs. Consequently, this has prompted traders to fully price in a quarter point rate cut next month with a strong possibility of further easing in the first quarter of next year. However Fed officials need to wake up and realize the strain that the US economy is currently facing. As recently as this morning, Fed President Evans and Plosser downplayed recession risks. Evans said that the spending outlook is favorable despite the worries of traders and analysts while Plosser said that lowering interest rates could cause more harm than good because it would lead to significantly higher inflation pressures. Tomorrow we are expecting the Beige Book report, which could go a long way in telling us who is right, the markets or the Fed. If growth in the individual districts are deteriorating, then that would validate the market’s belief that the odds for a recession are growing. If the districts report stability, the Fed would prove to be the wiser ones. The market and the Fed have both been wrong in the past with the markets overly pessimistic and pricing in downturns that never happened and the Federal Reserve not acknowledging that the US economy has fallen into a recession until after it has happened. Therefore the only things that we can rely on are economic data and so far economic data supports the market’s belief and not the Fed’s.