Wednesday, August 08, 2007

Fed fails to signal interest rate cut

Fed fails to signal interest rate cut
By Eoin Callan in Washington and John Authers in New York
Copyright The Financial Times Limited 2007
Published: August 7 2007 19:14 | Last updated: August 8 2007 00:40

The US Federal Reserve on Tuesday acknowledged for the first time that the current turbulence in the credit markets could threaten economic growth, but stopped short of signalling an interest rate cut later in the year.

Instead, while noting that market turmoil would increase borrowing costs for companies and consumers, the Fed retained a hawkish stance on inflation as it kept rates on hold at 5.25 per cent for the ninth straight meeting.

The Fed statement accompanying the decision said: “Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing.”

The statement did not halt volatility as equity investors reacted negatively at first, then reversed course. The S&P fell by as much as 1.4 per cent in an initial reaction to the statement before rebounding as much as 2.2 per cent from its lows of the day to close 0.6 per cent higher.

Bond prices also gyrated, with the yield on the two-year Treasury, which began the day at 4.51 per cent, falling as low as 4.42 per cent before hitting 4.56 per cent. Fed Funds futures indicated traders thought the chances of a rate cut this year had diminished slightly.

While nobody in the market had expected a cut on Tuesday, there were growing expectations that the Fed’s governors might remove language describing inflation as the “predominant risk,” as a signal of rate cuts in the near future. Some market commentators have said liquidity in the markets is so restricted that a “rescue” rate cut is needed to stimulate activity.

“Ultimately, they are going to have to cut,” said Bill Gross, managing director of Pimco, the giant fixed-income fund manager.

However, Drew Matus, an economist at Lehman Brothers, said: “Things would have to get significantly worse for the Fed to respond via a rate cut.”

Economists at the Bank of New York suggested the message was that the Fed had decided against a “pre-emptive” cut of 0.25 percentage points. Instead, if it did need to cut interest rates because of the subprime crisis, it would be an “after-the-fact rescue effort,” with a cut of as much as one percentage point.

The dollar weakened after the announcement, dropping by 0.5 per cent against the yen, and falling below the psychologically important level of Y118. It remained relatively stable against other currencies.

Lenders’ ability to sell debt to investors has been dramatically reduced in recent weeks amid severe credit market turbulence and reduced investor appetite for risk.

Hedge funds globally suffered their second-worst week in four years during the final full trading week of July as continuing concerns about the spread of US credit problems took their toll on performance.


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