Small Cuts Don’t Much Matter

Story Summary:

• Expectations for the Fed to cut its target Fed Funds rate next week have reached manic proportion but have little to do with economic reality
• The global economy is on solid footing and no action from the Fed is needed
• Even if the Fed cuts rates a little, it won't matter because small moves don't alter the economy much one way or the other

Throughout the week we saw headlines like "Stocks Rise on Hopes of a Rate Cut" in anticipation of Bernanke and his cohorts' FOMC meeting next week. Apparently, markets are "hoping" for lower rates. If the economy is sufficiently bad, then the Fed will lower rates and "save" it, which in turn will raise stock prices.

Today, stocks are flattish. The headline on Bloomberg reads: "US Stocks Drop after Retail Sales Trail Estimates, Credit Concerns Grow." But shouldn't that news be bullish? If the Fed needs evidence that the economy is weak and credit is toxic to justify cutting rates—that would be bullish according to today's wisdom, right?

(Of course that's ridiculous, but stay with us, it gets even better.) Apparently, even a small cut would not be good enough for markets:

The Fed's Unkindest Cut?
By Paul R. La Monica, CNNMoney.com

The caption reads: "Wall Street is certain the Fed will cut rates to ease the pain of the credit crunch. But how will investors react if Bernanke & Co. cut by just a quarter of a point?"

This is the kind of circular logic passing for reason in times like these: The worse the economy is, the better, so that the Fed can cut rates and save the economy. We don't buy it.

First, the notion Wall Street is "certain" the Fed will cut rates is inane. Were it true, folks would collectively breathe a sigh of relief and markets would surge leading up to the actual event. Obviously, that isn't the case.

When pundits say markets are "certain" of a Fed cut, they're referring to fed futures contracts, which have priced in several rate cuts before year end. But we wouldn't put much faith in fed futures.

Markets price in all well known information, but they're not a crystal ball. Fed futures contracts are explicitly not predicting the Fed's behavior—they're reflecting what the market thinks the Fed will do. But there's no good reason to believe the market knows how the Fed will act. (If you want to see some really wonky Fed prediction models, just Google "fed futures" and see what pops up.)

Today's Fed gives the public cryptic messages and relatively little concrete information about its intentions. Markets are not designed to predict the decisions of a few individuals in a closed committee using undisclosed information. Markets are effective as predictors when they have large amounts of information spread over a vast economic structure at their disposal—precisely not the breadth of information the Fed provides.

And there are good reasons to believe the Fed won't cut in the first place. Bernanke seems to recognize (quite rightly) the economy is in good shape and no drastic moves are needed. To our minds, the Fed has been deft and clever in handling today's credit worries.

The Greenspan Myth
Donald L. Luskin, Poor and Stupid

We quote from Mr. Luskin's article:

"To help the markets in those crises [1987 & 1998], the Fed opened its checkbook to provide the liquidity necessary for transactions to clear and credit to endure despite the chaos. That's precisely what Mr. Bernanke has already done in the present turmoil, both through a very high volume of ordinary open market transactions and a liberalized discount-window lending policy.

"In that sense, Mr. Bernanke has already acted more pre-emptively than Mr. Greenspan did in 1998, and similarly to the way Mr. Greenspan did in 1987 and September 2001. And he has done so despite the fact that, judging by the stock market's sturdy performance through the current turmoil -- now down only about 5% from all-time highs -- today's crisis is less threatening than those earlier ones."

Though the market is demanding a band-aid solution, cutting the Fed Funds rate doesn't solve much of anything in the short term. Rate cuts traditionally take well over six months before their effects fully hit the economy—so by definition they can't act as a stop-gap measure. What then would be the point of a rate cut but to "restore investor confidence?" If you believe that's a valid reason, then you must also agree today's market turmoil is a psychological problem, not a fundamental one.

We're not predicting the Fed's next move one way or the other. The point is, small cut or no cut, it doesn't much matter. The Fed Messiah Prophecy is psychology. Markets most often do just fine correcting themselves. Given an effective fed funds rate already hovering around 5%, a 0.25% rate cut from 5.25% to 5% isn't a big deal.

Unless the Fed really stirs things up with a huge move (possible, but highly unlikely), next week's FOMC meeting is not representative of a major inflection point for markets or the economy.

Sit tight and stay disciplined as this short-term, predominantly psychological, corrective phase works itself out. Fundamentals are pointing to a bright economic picture and very attractive stock prices.

Have a great weekend.