That notion is borne out by the July Fed funds futures contract, which, as of June 17, was pricing in a full 25-basis-point easing at the upcoming FOMC meeting. Also priced in is about 40% to 45% chance of an additional 25-basis-point cut, bringing the total rate reduction to half a percentage point.
However, those market players may be getting ahead of themselves. We at MMS International are betting that the Fed will opt for the less aggressive option of a 25-basis-point reduction. The big reason? Financial markets have already provided significant stimulus that should increasingly take hold as the second half progresses.
Financial Markets: Doing the Fed's Job?
Change since FOMC meeting
June 13 level
10-yr. Note (Yield)
The table above highlights the current readings in three benchmark financial-market measures vs. their levels at this year's three previous Fed meetings. The yield on the 10-year Treasury note, which we're using as a proxy for long-term rates, has dropped 70 basis points alone since the May 6 FOMC meeting. This suggests that the Fed's comments regarding deflation (see BW Online, 5/6/03, "The Fed Identifies a New Peril") were much more successful at lowering market yields than any 25-basis-point rate cut would have been.
HELP FROM THE DOLLAR. Rates haven't been alone in their journey south. The Fed's broad trade-weighted dollar index -- a measure of the greenback's strength -- is down over 5% from the Mar. 18 FOMC meeting. The dollar is off even more against the Major index, which gauges the U.S. currency vs. those of some of America's largest trading partners. Past Fed research suggests that such a decline may be equivalent to a 25-basis-point rate cut alone.
Stocks have headed in the opposite direction. The S&P 500-stock index is up 6% since the May meeting, 14% from the March meeting, and 25% from the March lows. This should not only add to any "wealth effect" that's already being supported by a robust housing market but it could also help to stoke business spending -- especially with the sharp decline under way in credit spreads.
In addition to these financial-market developments, fiscal policy could add a kicker over the summer that's equivalent to the impact of all these other measures combined. While the stimulus package signed by President George W. Bush on May 23 is billed as reflecting a legislative "compromise" at $350 billion, make no mistake about it -- the deal is significantly more front-loaded than many market participants appreciate (see BW Online, 5/30/03, "Just How Big a Stimulus?"). The bill's up-front stimulus is similar to that contained in Bush's initial $670 billion package, with some analysts forecasting that its economic boost could be equivalent to a full percentage point (100 basis points) drop in the Fed funds rate.
WRONG MESSAGE. Along with all this stimulus in the pipeline, signs are emerging that some of the more timely economic reports may finally be rebounding following the Iraq war (for example, the latest updates on the New York Fed's manufacturing survey and the National Association of Homebuilders survey). The May consumer price index report has also allayed some deflation fears.
Thus, the risk of the Fed overshooting its mark is compounded with a 50-basis-point cut. The central bank may also be worried that such a big reduction could send a message to the markets that it's done easing. This could counterintuitively result in a jump in long-term rates -- undermining the intention of the rate cut.
Finally, a 50-basis-point cut runs the risk of creating dislocations in money-market funds, which are already brushing dangerously close to producing negative returns as management fees exceed actual returns (see BW Online, 5/21/03, "Money Funds: Moving to the Red Zone?"). With the risk to that crucial asset class -- and signs that monetary and fiscal stimulus may be taking effect at last -- it's our guess that the Fed will see a smaller opening of the policy spigot as the more prudent decision. MacDonald is a senior economist for MMS International