Kamp's Comments - The Fed Keeps Taking Out "Insurance"

by Leo Kamp, Managing Director and Chief Investment Economist, TIAA-CREF

October 31, 2007
After a two-day meeting, the Federal Reserve choose to lower rates again today, following cuts they started to put in place in mid-September. This time the Fed only lowered their Fed Funds Target by ¼ of a percentage point (25 basis points), half the ½ percentage point cut installed in September. As a result of these two cuts, their Funds Rate Target now stands at 4.5% — a full 75 basis points below the 5.25% that prevailed for over a year.

Why did the Fed again cut rates? Well, this cut, as with the September cuts, represents an effort to buttress economic growth, which, in the Fed’s view, is now at risk of faltering in the wake of the housing slump and the financial seizure that arose from the sub-prime mortgage market meltdown.

While economic momentum continued recently (with today’s advance report showing Q3 real GDP came at an annual rate of 3.9%) despite a declining housing market, the Fed members have become increasingly worried in the last two months about the state of the economy. Their concerns about economic malaise taking hold have counterbalanced, at least to some degree, their ongoing worry about inflation rising. Moreover, with inflation still showing signs of moderating, they have increasingly focused their attention on the slower pace of the economy indicated by recent economic data. To a large degree, the rate cuts of recent months constitute the Fed’s taking out “insurance” against the economy slowing too much, perhaps even falling into recession.

Those rate cuts are an abrupt about-face for the Fed. Up until mid-August, the Fed maintained that inflation’s moving higher was their major policy risk, not the strength of the economy. Indeed, they continued to point to tight labor market conditions (as evidenced by an historically low unemployment rate) as possibly pushing wages and inflation higher.

In addition, the economy grew considerably above trend in the second quarter, with real GDP growing at an annual rate of 3.8%. If sustained near that above-trend rate in subsequent quarters, economic growth could cause further tightening labor market conditions (and push the unemployment rate down further) and eventually could drive wages and inflation to unacceptable rates. Hence, at their August meeting, the Fed maintained their funds target at 5.25% — the same rate that had been in place since June 2006.

Then came the meltdown in the sub-prime mortgage market. Within days, liquidity in key financial markets (for example, the asset-backed commercial paper market) dried up. Transactions of sub-prime related paper (including CDOs and SIVs) came to a screeching halt as market players became increasingly concerned about the risk that sub-prime related investments posed to their balance sheets and capital positions. With few transactions taking place, pricing of sub-prime investments became virtually impossible. Poor liquidity conditions in those markets led to still worse liquidity conditions in subsequent days.

By the middle of August, the Fed became extremely concerned about the fiercely tightening liquidity in the financial markets. At that time they, and other central banks around the world, started to inject sizable funds into financial markets via open market transactions and direct loans in an attempt to calm the markets and improve liquidity.

Despite these actions, major financial markets (particularly the equity markets and high-yield corporate bond markets) continued to decline and to be more volatile. Even after the Fed lowered the discount rate for loans from the Fed and made such loans available to a wider range of financial institutions, markets continued to correct and showed increased volatility. It was only after the Fed acknowledged the potential downside risks to the economy from this financial market turbulence and cut rates on September 18th that markets started to rebound and became less volatile.

So, what will the Fed do the next time they meet in December? As usual, much will depend on what the incoming data show. If the Fed sees signs of further economic weakness, they may again cuts rates to take out still more “insurance” against the economy faltering. However, they would probably not ease again if they see the economy holding up well and, with that, a greater risk of inflation moving higher (not an unlikely prospect given recently soaring energy prices and a very weak dollar).

In fact, if these latter circumstances were to prevail into early 2008, the Fed may at that time start hiking rates again, reversing the cuts they have put in place recently and possibly moving rates even higher than they stood in mid-September. Under those conditions, the Fed’s main concern would again be inflation getting out of control, not the economy faltering.

Leo is also available to comment on economic data. If you wish to speak with him, or to be removed from future distributions, please notify Chad Peterson at 212 916-4808.

Kamp’s comments are prepared by TIAA-CREF Asset Management and represents the views of TIAA-CREF’s Investment Strategy and Client Solutions Group. these views may change in response to changing economic and market conditions. Past performance is not indicative of future results. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons.

TIAA-CREF Asset Management is a division of Teachers Advisors, Inc., a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA). TIAA-CREF® personnel in its Investment Management area provide investment advice and portfolio management services through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association® (TIAA®). TIAA, TIAA-CREF, Teachers Insurance and Annuity Association, TIAA-CREF Asset Management and Financial Services for the Greater Good are registered trademarks of Teachers Insurance and Annuity Association.

About TIAA-CREF: TIAA-CREF is a national financial services organization with over $400 billion in combined assets under management as of 9/30/07, and the leading provider of retirement services to individuals and institutions in the academic, research, medical, philanthropic and cultural fields.  Further information can be found at www.tiaa-cref.org.

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© 2007 Teachers Insurance and Annuity Association-College Retirement Equities Fund, New York, NY. 10017


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