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December 9, 2007

John Berry: Markets Are Normalizing, Causing Dilemma for Fed

John Berry says the Fed faces a tough decision on whether to cut the target rate:

Markets Are Normalizing, Causing Dilemma for Fed, by John M. Berry, Commentary, Bloomberg: Federal Reserve officials' decision to provide liquidity to credit markets rather than an interest- rate cut appears to be paying off.

With the Fed supplying funds to relieve the sudden cash crunch, investors have had time to begin to distinguish good credits from bad. As a result, large portions of the market have begun to normalize.

That's good news for Fed officials, because it's clear they would prefer not to lower their 5.25 percent target for the overnight lending rate. And they certainly have no intention of doing so before the Sept. 18 meeting...

The normalization process, which has a long way to go, is even occurring in the market for mortgage-backed securities. ...

The effective overnight lending rate has moved close to the 5.25 percent target after Fed injections of cash kept it well below that level for most of two weeks. Treasury bill yields, which had plunged in the middle of this month, have bounced up by more than a percentage point.

And this improvement has come against a background of lessening concern that a major U.S. financial institution might be brought down by losses related to subprime mortgages. Banks are going to take a hit on earnings, not anything more than that.

Economist Paul Ashworth of Capital Economics in London said yesterday that the Fed now faces a dilemma over what to do about the lending-rate target.

'The markets have a 25 basis point cut fully priced in for the meeting on Sept. 18 and anticipate further cuts after that,' Ashworth said. 'But equity and credit markets have begun to normalize...

'The recovery means that the immediate need to cut the Fed funds rate has receded. If the Fed fails to deliver a rate cut, however, markets could go into a tailspin again,' Ashworth said.

Another Tailspin? Would they? ...

Markets are likely to remain volatile regardless of the outcome of the meeting, and officials aren't going to let that fact sway their decision.

What will matter most -- ... assuming no new credit- market meltdown -- will be their assessment of how much the economic outlook has changed.

In a statement issued Aug. 17, the committee said that because of the big change in financial market conditions 'the downside risks to growth have increased appreciably.' So already the FOMC had swung from emphasizing the risk that core inflation would not moderate as expected to worrying about slowing growth.

Among the risks, of course, are that the problems in the housing market, including falling home prices, and declining stock prices will hurt consumer spending. Consumer confidence is dropping after all.

On the other hand, employment is still rising, as are wages, and when household incomes go up, spending usually does.

Just as the earlier concern about core inflation didn't trigger a rate increase, shifting to concern about growth doesn't mean a rate cut is foreordained. ...

Nothing about the choice on Sept. 18 will be simple. Nor will be the full normalization of credit markets. ...

I still don't think the Fed will make a move contrary to expectations, and as of now a rate cut is widely expected, so it will be interesting to see if there are any signs that Ben Bernanke is trying to shift those expectations in his speech later today.

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