The Federal Reserve begins its two day meeting today that is widely expected to result in another 50 bp rate cut that will bring the target to 1.0%.  Given that deflationary forces from the collapse of the credit cycle have still not been seen, the FOMC may be reluctant to deliver a larger rate cut.  One of the Fed’s often cited measures of inflation expectations--the 5yr/5yr forward has risen markedly in recent weeks.  After bottoming just below 1.7% on Oct 8, it is now quoted near 2.46%.

This is seen as the expected rate of inflation. Admittedly there may be a liquidity premium.  In comparison the French 5yr/5yr forward is still trending lower is now dipping below 2.00%. It is true that the US has been more proactive with both monetary and fiscal policy than Europe. 

At this juncture, a 25 bp rate cut that some observers think is more likely, seems to unnecessarily risk disappointing the market and moreover, does not appreciate the powerful headwinds that are causing the US economy to contract and contract severely.

The 1% target rate was seen earlier this decade amid a deflationary scare.  It does seem a bit ironic that some observers blame the 1% Fed funds rate and the length of time it stayed low as one of the key factors that fueled the credit orgy, but it will be noted that even countries that did not lower rates nearly as much also gorged themselves with leverage.  Also, the Greenspan conundrum, it will be recalled, was why long-term rates stayed so low even as the Fed hiked And this answer Bernanke gave was one of surplus savings.  The same force also helped buy European bond yields down, as well as emerging market bonds. 

A 1% Fed funds target now is not the same thing as it was then.  Because inflation is higher, real rates are lower.  In addition, after having only 6 quarters of negative growth in the past quarter of a century, there is serious risk of a protracted contraction now that could last 3-4 quarters. 

That said there is nothing sacrosanct about a 1% Fed funds rate.  The risk is that it falls below there in this cycle, perhaps even by the end of the year.  The effective Fed funds rate (weighted by volume) has not been above 1% since Oct 15.  A case can be made that the Fed has downgraded the significance of the Fed funds rate through its provisions of liquidity and expanding its own balance sheet dramatically.  The Fed appears to be edging toward a quantitative ease. 

The statement from the Fed may also not tell the market anything it does not already know.  At the time of the inter-meeting (coordinated) rate cut on Oct 8, the Fed’s statement was instructive.  It expressed concern about the marked slowing of the economy and the intensification of the financial crisis that would likely hurt the real economy more.  Not only were the downside risks to growth underscored, but the upside risks to inflation were thought to have lessened.