The Fed: expect a 25 basis point cut

It was always going to be courageous to make an interest rate call before knowing the key data, but we were asked for an early view last Monday and leant then towards 'no change'. At the same time we stressed that the data could still tip the balance of risks towards a cut. In the event this is what has happened. We now expect the Fed to cut interest rates by 25bp on Wednesday. This would take the Fed funds rate to 1.50%.

The Fed has kept rates at 1.75% for a year and has been keen to allow monetary policy to work via the longer-end of the curve. In recent months the Fed has reverted to an easing bias, citing weak confidence as a major concern. Reports last week of a collapse in consumer confidence and a further fall in the ISM survey of manufacturing should therefore be decisive. Although not as bad as had been feared, the ISM index was still below the key 50 level for the second month running.

Market expectations seem evenly divided between a cut of 25bp and 50bp. We think there are enough positive signs in the recent data to allow the Fed to limit the cut to 25bp, notably the rise in the new orders component of the ISM and the resilience of payrolls. Given the current low level of rates, a 25bp cut is still a big move. The Fed may also want to keep cuts in reserve. If the Fed does not cut at all, markets would be disappointed and equities would be vulnerable.

The market implications of a rate cut would depend partly on the accompanying statement. Both currencies and interest rate markets will probably take their lead from equities. The key point is that a rate cut would be designed to boost confidence and the reaction of equities will be the first indicator we will have of this. We expect this reaction to be positive. The trick will be to convey the message that the Fed is taking out a little insurance now and could take out more later, but is not overly worried about a double-dip back into recession. This could be achieved by maintaining the bias towards easing while emphasising the favourable longer-term fundamentals in the US economy.

Assuming that equities react positively, the dollar should too. Currency markets are now rewarding pro-growth policies, so the euro is vulnerable this week if the ECB drags its feet. Similarly if equities react positively, interest rate markets are less likely to price in further cuts after Wednesday and the curve should steepen.

The other key event this week is the US mid-term elections on Tuesday. If the Republicans regain control of the Senate and keep control of the House (which looks a fair bet), the Bush administration will press ahead with further tax cuts including the elimination of taxes on dividends. This would be positive for equities and at least in the short-term for the dollar, while likely to contribute to a steepening of the yield curve.

ECB - expect 50bp in December

The ECB should cut rates aggressively, but probably won't - at least not yet. It remains concerned about the recent inflation data and the disputes about the Stability and Growth Pact. The main factor that might change its mind is therefore not the Fed decision but the regular discussions of European Finance Ministers this Monday and Tuesday. A stronger commitment to fiscal discipline may influence ECB president Duisenberg, who will attend the meetings. But without this commitment, we expect the ECB to delay a larger rate cut until December. Further easing is likely in 2003, linked to a change in the inflation target or a sharp fall in oil prices.

Bank of England - expect 25bp this week, just

It is an even closer call on the Bank of England. The UK economy is still doing well: growth is close to trend, inflation will be back at target rate soon, and there are valid concerns about the high level of household debt. The Bank could be content to let the Fed deal with the concerns about the US. However, it will probably have less confidence about the ECB's ability to help Euroland, where the economic slowdown is starting to have a major effect on UK business confidence. This MPC meeting will also precede the publication of the quarterly Inflation Report, which could provide additional justification for a rate cut. The risk of making a mistake on inflation is small compared to the risk that the economy will slip back into recession. At the start of 2002 we were one of the few institutions predicting that the Bank would cut rates again. Rather than sit on the fence, we are happy to reinstate that view.

Julian Jessop
Senior International Economist
Tel: 44 20 7280 6690

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