As is now customary, I will go on the the record about what I think the Fed will do tomorrow. So far, I'm 0-for-1, for those of you keeping score. The Fed will cut both rates 25bps, really for no other reason than they have primed the market with that feeling. Fifty basis points looks aggressive here, especially give equity prices, but, in fairness, I said that last time. Postponing a cut until December is inconsistent with Fed actions in general. Rarely does the Fed do one and done. What will be most important about tomorrow's announcement will be what they say going forward. The Fed needs to throw something to currency market, to at least keep the decline of the dollar steady. What would work would be a statement to the effect that the Fed is going to gauge the effectiveness of recent cuts on the economy, markets, etc. They can get away with this because it is generally accepted that it takes some time for these moves to filter through the economy. Then they throw in the boilerplate language about standing ready to act if necessary, yada, yada, yada, to keep equities from selling off 10%.
With one more meeting this year, the Fed is in a tough spot. They don't have as much room to maneuver. Next year, being an election year, the Fed will be more hesitant to act. There is no incumbent up for re-election, so it does give them more flexibility. They may not need to do much more anytime soon. However, the Fed need to telegraph its thoughts now that it can't solve the subprime crisis or bail out homeowners that bought more than they could afford by themselves; market-based solutions are what is needed in both cases. Otherwise, it will be a tough '08.
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I don't think Bernanke wants to cut, but feels he must to preserve orde rin the financial system. He also has Fredric Mishkin (who favors aggressive cutting when necessary) whispering in his ear. I do think the Fed will use language that stresses policy changes should the economy sho signs of weathering the hosuing storm.
The Fed needs to be concerend wit two things. First, November has mega ajustable-rate mortgage resets instore. Secondly, Wall street firms HAVE NOT fully reported their losses due to SIVs and CDOs. Merrill may have ben the most upfront with its losses.
Some firms may be deliberately holding back, but many (if not most) have no clue as to what their investments are worth. It has been reported by Bloomberg that Merrill may have to write down another $4 billion. Following Merrill's announcment, a rumor went around Wall Street that Lehman may report writedowns betwen $9 billion and $10 billion when it reports in December. That seems a bit large for a firm of Lehman's size, but who knows these days.
As for the dollar, the two camps are starting to fire up thr rhetoric. Those who want a strong dollar are calling for the Fed to hold the line on rates and to begin tightening in 2008. Those who believe that increased exports are our salvation are enjoyig the weak dollar. They laud the narrowing trade deficit.
The truth is that a trade deficit is the sign of a helathy economy. When you can buy more of your neighbors goods than they can buy of yours is a good thing.
The weak dollar is probably a limited-time phenomenon. The belief that the U.S. has decoupled from the global economy is bunk. We may not be as singularly dominant as during most of the post-war period, but we are still the biggest market for foreign exports. Eventually, if consumer spending wains, foreign economies will feel the impact as well. Wait and see.
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