Monday, September 17, 2007

While We Await Uncle Ben's Rate Cut

Wall Street is eagerly awaiting the Fed meeting tomorrow, hoping Ben Bernanke will cut 50 basis points from the Fed's benchmark interest rate and signal that more cuts will be coming down the road.

The Fed Fund Futures are pricing in a 42% probability of a 25 point interest rate cut versus a 58% probability for a 50 point rate cut from the current 5.25% rate.

If the Fed does cut rates, this will be the first interest rate cut after the Fed raised rates 17 times, going from 1% in June 2004 to 5.25% in June 2006.

I have a feeling that Bernanke will only cut the Fed rate by 25 basis points and will signal that inflation remains a concern.

Here's why:

Goldman Sachs is forecasting oil will increase to $85 by the end of the year and could hit $90.

Agriculture prices have been surging - wheat prices are at all-time highs in the Asian markets and wheat supplies are near all-time lows.

Gold and other commodity prices continue to rise.

Bernanke will lower rates, there is little doubt of that.

The weak August job numbers gave him cover for that.

But I just don't see how he justifies lowering the rate by more than 25 basis points when prices are so high and the Fed has been using inflation as an excuse to NOT cut rates for the last year when Wall Street investors were clambering for one.

Plus, he has to make a statement saying something like the "Fed will do everything it can to ensure growth and liquidity but must maintain vigilance against inflationary pressures."

If Bernanke does issue that kind of statement, I bet Wall Street doesn't rally, even after it gets its rate cut.

After all, investors are greedy - they want assurances from Ben that they're going to get larger and more frequent rate cuts through the end of the year.

UPDATE: Last night on 60 Minutes, Uncle Alan Greenspan repeated his warnings that inflation will be a big future problem and double digit interest rates will be needed to contain those pressures:

WASHINGTON (MarketWatch) -- Former Federal Reserve Board Chairman Alan Greenspan says his outlook for the future of the U.S. economy is "pretty gloomy."

In an interview with correspondent Lesley Stahl of the CBS News program "60 minutes," Greenspan said that over the long run, the biggest problem facing the U.S. economy is "the re-emergence of inflation," and rising interest rates.

How does Uncle Ben give Wall Street a full 100-200 basis points rate cut when inflation looms as such a problem and Uncle Alan says double digit interest rates will be needed again in the future to contain that problem?

I think we are pretty much in agreement on the prediction, although I still think there is a chance rates stay on hold (although that is probably a snowball's chance in hell).

The one thing you don't mention, and must be on Bernanke's mind is the impact on the dollar. A 50bp cut in the face of an October hike from the ECB is absolute suicide for the greenback.

Also interesting to watch will be the PPI and CPI data straddling the announcement. Just imagine if those surprise to the upside. O.K. now I'm getting ahead of myself.
With the mortgage mess, I see a perfect storm on the horizon, on a course to hit Texas hard. While Texas has no income tax, it depends heavily on some of the highest property tax rates in the country (as well as a 7.75% plus sales tax rate) to finance state, municipal, and school operations. Washington's withdrawal from financing of programs shared with the state, plus the added cost of federally-mandated programs, have put Texas, among others, in a bind. For the last couple of years, budgets have been managable only because the increase in property valuations has put increasing amounts of money in state and local hands. As a result, many projects that are merely 'nice' but inessential have found their way onto the books.

Should the growth in property tax revenues not appear as planned, there will have to be some serious belt-tightening, to say nothing of what will happen as property values actually decline. Somehow, I don't see some of these 'nice' but inessential projects that have the backing of developers and fat cat powers that be being the ones that are given a serious haircut. The burden of the lack of money is more likely to fall on the usual suspects -- health and public assistance, colleges and public schools.

I don't know how the resulting chaos will be resolved, but I can hear the Bush White House preparing its denials of any responsibility already.
Well, I was completely wrong. 50 basis points for both the benchmark rate and the discount window rate.
I'm not a religious man, but God save us all.
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