Could the Federal Reserve Cut by Another 100bp in 2008?

Last year, the Federal Reserve cut interest rates by 100bp to prevent a major slowdown in the US economy. Although their efforts have forestalled a recession, it has not prevented one from potentially happening in 2008. Non-farm payrolls in the month of December were abysmally weak, leading many bank analysts to revise their calls for how much the Fed will ease on January 30th. One week ago, the futures market was only pricing in a 30 percent chance that rates will be at 3.5 percent by the end of April (which is 75bp below current levels). However after the release of December non-farm payrolls, the market started to price in as much as 100bp of easing over the next 4 months. 100bp in 2007 and 100bp in 2008 would bring rates down to 3.25 percent, the lowest since June 2005. We believe that the chance for interest rates in the US to be 3.25 percent or lower by the end of 2008 is high, but whether half of that easing will happen in January remains to be seen. The growth of 18k jobs in the month of December was the weakest that we have seen since August 2003 when the US economy shed 42k jobs. Unfortunately there was no silver lining in the report. A look into the details reveals that if the government did not increase public sector hiring, job growth would actually be negative last month. On top of that, the unemployment rate increased to a 2 year high while the annualized pace of earnings growth slowed from 3.8 to 3.7 percent. These levels indicate that we are either already in a recession or headed for one. Within seconds of the data release, the US dollar fell 100 pips against the Japanese Yen as the futures market began to price in a greater chance for a 50 vs. 25bp rate cut at the end of this month. Although the Fed could cut rates by 50bp, we doubt that today’s non-farm payrolls number has cemented their decision. There are still 18 trading days until their monetary policy meeting. If oil prices break $100 a barrel and consumer prices or retail sales surprise significantly to the upside, the Fed could opt to drag out their easing cycle into the summer and lower rates at 25bp clips instead of acting more aggressively by cutting rates 50bp in January. In the week ahead, there are a lot of speeches by Fed officials but no meaningful US data until Friday. The US dollar should continue to weaken, but we would not be surprised to hear see new measures from the Bush Administration to stimulate growth.