Forex Investment and Currency Trading

The Fed’s decision to lower its Federal funds rate target 75 basis points to 2.25% was less than financial markets had predicted in the futures market. Two members voted to dissent from the aggressive reduction in rates, arguing for more caution in the face of inflation pressures, but the Fed’s emphases in its announcement that “the outlook for economic activity has weakened further” and that “downside risks to growth remain”, clearly point to further monetary easing. The discount rate was cut to 2.5%, maintaining the 25bp penalty rate established March 16.

The Fed carefully spelled out the downside economic risks: slower consumer spending, softening labor markets, considerable stress in financial markets and the deepening of the housing contraction. The funds rate is now below both headline and core inflation, and is also below select measures of inflationary expectations. Several Fed members have already indicated that the lowering of real interest rates is effectively an offset to credit stress and rising credit spreads.

The elevated concerns about inflation, highlighted by 2 official dissents—Charles Plosser, President of the Federal Reserve Bank of Philadelphia, joined Dallas Fed President Fisher— illustrates the dilemma facing the Fed. These two dissents—a rare occurrence—are an accurate reflection of the public statements made by these FOMC members.

These dissents and the inflation concerns expressed in the Fed’s announcement suggest that the Fed has not lost its long-run objective of low inflation. The Fed is warning financial markets that eventually it must raise rates to be consistent with that objective. However, the Fed clearly acknowledges the weakened economic outlook and the potential downside risks posed by credit stresses. Last week’s rate reduction, along with its enhanced lending facilities during the prior week, highlight the Fed’s overriding near-term priority is to restore financial market order and limit the fallout of financial stresses on economic performance.

We expect that in response to upcoming soft economic data, including further declines in employment and a rise in the unemployment rate, the Fed will cut the Federal funds rate further. We continue to expect the funds rate to reach 1.5%. Eventually, the Fed will raise rates, but credit stresses likely will elongate the lags between monetary easing and accelerating aggregate demand, so any reversal in these rate reductions are a ways off.