Is the Fed Pushing on a String?

10/18/2007 12:00 am EST

Focus: MARKETS

Gary Shilling

Columnist, Forbes

A. Gary Shilling, president of A. Gary Shilling & Co., says the central bank will continue to cut rates this year and next to try to ward off impending recession.

Did the Federal Reserve flinch when it cut its discount rate and federal funds rate, both by 50 basis points, on September 18th?

Financial markets think it did, and [that it] was more worried about the health of the financial markets than about creating further moral hazard.

That's when the central bank signals that it will bail out speculators with credit ease and by so doing, encourage even more risk taking. Many believe former Fed Chairman Alan Greenspan did just that and that the "Greenspan put" has been followed by its legitimate son, the "Bernanke put."

Furthermore, futures markets now assume that the Fed will continue to cut rates significantly. The broad and deep eurodollar market, where yields are closely linked to the federal funds rate, assumes that the latter will fall over 100 basis points by June 2008. And the rally in stocks says investors believe the Fed has forestalled any threat of recession.

So, market action implies that the Fed has saved the day. The August winter of credit crunch discontent has been warmed by the sun of credit ease. And lower economic growth in coming quarters, the consensus is convinced, is just a mid-course correction in the expansion that started in the fourth quarter of 2001.

Even in the midst of the August disruptions, most forecasters did not expect recession any time soon. A Wall Street Journal poll in early September found that the risk of a recession in the next 12 months was 36% for the average forecaster, up from 28% a month earlier, but that means that the odds of no downturn by those surveyed was 64%.

The Fed will probably reduce its federal funds target and the discount rate at least once more before year's end and continue to cut as a recession unfolds in 2008. When the central bank begins a campaign to raise or lower rates, it usually continues for many steps and for years.

The funds rate could return to 1% from the current 4.75% if severe financial crises spread from subprime mortgages to the rest of housing and to other areas of intense speculation in recent years, such as junk securities, emerging market equities and bonds, commercial real estate, and commodities.

The Fed's patriotic easing in the face of deteriorating economic and financial conditions will help shield it from political criticism, but [will] do little to revive the economy or markets any time soon.

Equity investors in coming months will probably be more worried about collapsing corporate profits and financial problems than cheered by Fed rate cuts. It could well be a classic case of the central bank pushing on a string: in effect, the Fed's recent and future ease probably amounts to glorified jawboning.

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