The Federal Open Market Committee (FOMC) opted for an aggressive 50-basis point cut in the Fed funds rate to 4.75%; this is the first 50-bps cut since November 2002. In addition, it also cut the discount rate by 50-bps to 5.25%.
With the discount rate at 5.25% and the funds rate at 4.75%, the move increased the difference between the two rates to 50-bps, the same margin prevailing before the 50-bps rate cut in the discount rate on Aug. 17. This may mean that the Fed’s next policy easing would target the discount rate by 50-bps, bringing them to the same level. Recognizing that discount borrowing was on the rise last week to its highest level in six years at $7.2 billion, the Federal Reserve will want to preserve the effectiveness of the discount rate by cutting the funds rate at subsequent actions, whether scheduled or unscheduled meeting, and trigger a positive shit in the arm for the markets.
It is plausible that today’s 50-bp cut in the funds rate was aimed at stabilizing market confidence and shoring up liquidity with the intention of seeing improved market dynamics help the economy, while stepping back and exploring the macroeconomic landscape, including the upside risks to inflation.
This argument is based on the rationale that the macroeconomic data, while pointing to clear evidence of weakness (home prices/sales, construction spending, retail sales, jobless claims), the deterioration has been slow and gradual. Despite showing declines, ISM services and manufacturing remain above 50, never a coincident figure for 50-bp cuts. And despite weakening payrolls, jobless claims have yet to display aggressive gains as they are only at four-month highs. Finally, measures of consumer confidence remain modestly weak and well above the lows of the market turbulence of 1998 and 2001.
Consistent with the aforementioned analysis, the FOMC reminded markets that “some inflation risks remain, and it will continue to monitor inflation developments carefully.” This is an important reminder considering the central bank considering that it made no mention of its much-touted inflation risks at the inter-meeting rate cut on Aug. 17.
With the new post-Greenspan Fed proving its capability of starting the easing campaign with a unanimous 50-bp rate cut, currency markets are expected to engage in a combination of dollar-targeted trades (selling USD vs. EUR, AUD, CAD and NZD), with a touch of risk appetite trades weighing on the Japanese yen to the benefit of EUR, CAD, NZD and GBP. Unlike in 1998 and 2001 when Fed rate cuts boosted the dollar, the current global economic landscape is characterized by a unique decoupling of central bank policies from that of the Federal Reserve. Even if the European Central Bank (ECB), Bank of England (BoE), Reserve Bank of Australia (RBA) and Bank of Canada (BoC) remain on hold, a lack of easing is already a positive for their currencies against the U.S. dollar.
Ashraf LaidiChief FX AnalystCMC Markets USa.laidi@cmcmarkets.com
