Why Bernanke Won't Save Investors

After the stock market's plunge, investors are betting that the Fed could cut rates as early as August. Don't count on it

by Peter Coy

After the stock market's late-July rout, plenty of pundits assume the cavalry will come to the rescue. They say it's a near certainty that the Federal Reserve will cut interest rates to keep credit conditions easy and the economy growing.

But will the Fed cut? Don't be so sure.

Federal Reserve Chairman Ben Bernanke and his fellow rate-setters have been saying all along that they regard inflation as a greater threat than slow growth. And the real economy—as opposed to the financial markets—remains reasonably healthy. The Commerce Dept. reported July 27 that the gross domestic product grew at a brisk annual rate of 3.4% in the second quarter. So, unless the market downturn snowballs, a 2007 rate cut remains not much more than a 50-50 likelihood. There's even a chance that the Fed's next move will be to raise, not cut, interest rates.

Playing It Safe

It's easy to understand how people got the idea that the Fed is going to open the money spigot. Spooked in part by worse-than-expected news on housing sales, the Dow Jones industrial average closed at 13,406 on July 27, a decline of 600 points from its all-time high—a shade over 14,000—just eight days earlier. Stocks from ExxonMobil (XOM) and Bristol-Myers Squibb (BMY) to Net player Akamai Technologies (AKAM) and homebuilder WCI Communities (WCI) have taken it on the chin (see BusinessWeek.com, 7/27/07, "Uncertainty Reigns on Wall Street").

Fixed-income investors lost a lot of their appetite for risk: Investors abandoned junk bonds and other high-yield securities for the safety of U.S. Treasury bills, notes, and bonds. Investment bankers were left holding $20 billion from two leveraged buyouts in motion, the deals for the Chrysler unit of DaimlerChrysler (DCX) and for the British pharmacy chain Alliance Boots. Fear seemed to overtake greed as the primary emotion on Wall Street.

But remember, it's not the Fed's job to bail out stock and bond investors. The Fed takes notice of the financial markets only when conditions there threaten to cause a genuine credit crunch—that is, when even credit-worthy companies and families can't borrow money. We're still far from that scenario. In the mortgage market, for example, prime borrowers are getting, if anything, even more offers of credit because lenders need to make up for their lost subprime business.

Not a Sure Thing

Where did the idea arise that the Fed was certain to cut? Partly from the federal funds futures market, in which speculators bet on the likely level of the federal funds rate. That's the rate on overnight loans between banks that the Fed controls by adding and subtracting reserves in the banking system. It's currently at 5.25%. The implied rate for the December futures contract fell to just over 5%, leading some analysts to proclaim that the markets saw a "100%" chance of a Fed cut by the end of the year.

But markets never see a 100% chance of anything. Traders recognize that there's no such thing as a sure bet. The just-over-5% figure represents the weighted average of bets by people who predict the rate will be anywhere from 5.5% to 4.5%, or beyond, by December. A more sophisticated way to analyze the market is through options analysis. According to Bloomberg Financial Markets' options analysis of the fed funds market, as of July 26, the markets were seeing a 43% chance of no change in the rate by December, a 20% chance of a cut to 5%, a 28% chance of a cut to 4.75%, and a 5% chance of a cut to 4.5%.