FOMC Rate Decision 9-18: Scenario Analysis

The least likely scenario: Some analysts call this week's expected rate cut "the most forecasted rate cut in history". If the Fed left rates unchanged, markets might conclude the Fed is not being aggressive enough to avoid a recession. By linking the trouble in housing and credit markets with consumer spending in a speech last week, voting member Mishkin confirmed that the Fed is about to cut rates. In another scenario, the Fed could leave rates unchanged and once again cut the discount window rate. "The nearly universal belief that the Fed will cut rates next week is a little worrisome since there still is a viable argument for the FOMC to hold rates where they are," said Gregory Drahuschak at Janney Montgomery Scott.

Unlikely scenario: A 50bps rate cut would send a signal that the Fed wants to stabilize financial markets as quickly as possible, but if this was their intention they would have already cut rates long before this week's meeting. Bernanke has made it clear that it isn't the Fed's job to keep the U.S. out of near-term recession at the expense of long-term stability, and for this reason it makes no sense for them to cut so aggressively with so little economic data to show the impact of recent market turmoil (the "moral hazard" argument comes into play). A 50bps rate cut could potentially derail the USD and ignite inflationary pressures, a scenario the Fed obviously wants to avoid.

Most likely scenario: The Fed is expected to cut by 25bps, cutting by the smaller amount to demonstrate that the issue is under control and the risk is in the process of being re-appraised. A 50bps rate cut might be seen as a panic move. Short-term borrowing markets are showing some signs of stabilizing, the stock market appears to be in decent shape, and some credit is starting to move, suggesting that a 25bps rate cut would make sense. In the event of a 25bps rate cut, the accompanying statement will dictate near-term stock market direction.

FOMC statement after a 25bps rate cut: The Fed has recently avoided hinting at future policy actions, instead choosing to affirm their data-dependency stance. Under Bernanke, there is a preference for clear, official channels of communication. Speeches aren't the vehicle for expressing committee-wide views. The Fed refuses to hint at future action since they lack the data necessary to make decisions, and for that reason the accompanying statement on Tuesdays is unlikely to provide any fireworks. The most likely scenario is a comment along the lines of "we will act as needed". The Fed hasn't seen enough data to say "that's the only rate cut you'll get" (a strong inflation reading on Wednesday, not unlikely given recent USD weakness, may limit the Fed's ability to deliver more rate cuts). Given that we've already seen an anticipatory stocks rally ahead of the FOMC, a 25bps rate cut and an in-line Fed statement may provide limited upside for stocks.

Medium term Fed outlook: The consensus is that the Fed will take an incremental approach to cutting rates. Over the near-term, as adjustable-rate mortgages reset, defaults and foreclosures are likely to rise. This probably means a series of additional quarter-point rate cuts as the Fed gets ready for mortgages to be reset at the start of 2008. Investment adviser John Mauldin released a report focused on the month-by-month dollar amounts of mortgages that will be reset through 2008. The report shows that the largest reset amounts occur in the first six months of next year. Mauldin points out that the $197 billion of mortgage resets so far this year is "less than we will see in two months (February and March) of next year. The first six months of next year will see more than the total for 2007, or $521 billion."

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