Fed Cuts Discount and Fed Funds Rate by 50bp

The Federal Reserve delivers a double whammy. For the first time in over a year, the Fed cut the Federal Funds rate by 50bp to 4.75 percent while at the same time reducing the discount rate by 50bp to 5.25 percent. This follows an earlier discount rate cut of 50bp in August and represents a very aggressive step by the Federal Reserve to calm the credit markets. They are not going to let inflation risks hold them back from throwing everything they have at the market. This will go a long way to boost confidence because it indicates that the Fed is being proactive which may actually be enough to prevent a recession from happening. However for some skeptics, they will see this as a sign that the Fed thinks the problems in the US economy have gotten so severe that a big step is warranted.

As for future interest rate cuts, they did not commit to anything. The interest rate curve is actually now pricing in 4.25 percent rates by the end of the year. This means the Fed will need to deliver another 50bp of easing before Christmas.

With the odds for a 25 or 50bp rate cut essentially fifty-fifty, no move by the Federal Reserve today could have satisfied everyone. Their choice was particularly difficult this time around because they needed to walk a fine line between taking the necessary steps to make sure that growth does not slow materially while at the same time ensuring that inflation does not get out of hand. Oil prices climbed to another record high today and even though the August producer price figures showed softer inflation pressures, inflation is should have picked up again in September. As a self professed inflation fighter, Bernanke has probably given into political and market pressure.

The dollar fell significantly after the release, sending the EUR/USD to a record high of 1.3969. The stock market rallied over 100 points, taking carry trades higher in the process. Expect further dollar weakness in the days to come and expect further strength in the stock market and carry trades.