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U.S. rate cuts: Is easing over, or just paused?
Clément Gignac
Chief Economist and Strategist
National Bank Financial
May 2, 2008
On Wednesday April 30, the U.S. Federal Open Market Committee (FOMC) lowered its key policy rate another quarter-point, to 2%. It has now eased a cumulative 3.25 percentage points since September. The Fed continued to acknowledge weakness in residential real estate and ongoing tightness in credit markets, but it now believes that its substantial monetary easing since September has mitigated the risks to the economy. It dropped from its statement the note that "downside risk to growth remains." In short, the Fed intends to stay on the sidelines for a while.
At this writing we find it too early to say that Fed easing is over. The U.S. central bank kept cutting rates for 18 months after the 1990-91 recession and for 20 months after the 2001 recession. As the chart below shows, those long tails coincided with the period during which the unemployment rate kept rising.
When the FOMC eases to ward off a recession, it tends to head for a real policy rate (nominal rate minus core consumer price inflation) that is close to zero or negative. This has now been achieved: the Fed’s rate-cutting since September has been the swiftest of any postwar cycle.
So the Fed is now where it needs to be. However, the key to whether the Fed eases further or keeps rates steady will be future movements of inflation. At this writing we expect inflation to subside over the next four quarters, implying more downside for the policy rate.
As noted above, the unemployment rate is also critical in signalling a trough in interest rates. We think the U.S. labour market will continue to deteriorate for some time. This view is most recently supported by the April plunge of the Conference Board confidence index to a five-year low of 61.4. All of the deterioration was in the present-situation component of the index, driven essentially by the labour market. In the April survey, 28% of respondents, the most in four years, said jobs were currently hard to get. As the next chart illustrates, this is a strong signal of a soaring unemployment rate in the coming months. Our current forecast is 6.2% by the end of 2008.
In short, the Fed has taken the bull by the horns and added much-needed liquidity to what was a very dehydrated financial system. Now it plans to wait and see how its policy changes affect the real economy. However, we do not exclude the possibility that the Fed will be forced to cut rates again to fight disinflationary forces arising from the negative wealth effect of the housing slump.
Have a good week!
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