Economic Outlook: Battered investors look to Fed on rates

Market sentiment remains extremely fragile and further volatility appears the only certainty for bruised and battered investors who are wondering if the Federal Reserve will follow its efforts to improve liquidity conditions with an early cut in interest rates.

The Fed’s decision on Friday to lower the discount rate by 50 basis points to
5.75 per cent, an attempt to provide liquidity to market segments where it is really needed, surprised investors and led to a rebound for equities.

Accompanied by an acknowledgement that “downside risks to growth have increased appreciably”, the move heightened speculation that a cut in the Fed Funds rate, the main US interest rate, could follow.

“If the move does not alleviate the liquidity problems gripping the markets this week, then the Fed can be expected to introduce an emergency cut in the Fed Funds rate, probably within a matter of days,” said Paul Ashworth of Capital Economics.

Marco Annunziata, chief economist at HVB describes a rate cut as “a very concrete possibility” but not “a foregone conclusion”.

“The re-assessment of macro risk is also a powerful signal. The Fed recognizes that unless market conditions stabilize, the real economy will be hit, and stands ready to act preemptively if needed,” says Mr Annunziata.

However, other analysts such as Stephen Lewis of Insinger de Beaufort argue that a Fed Funds cut might be less likely after Friday’s technical step which reduced the cost of short-term credit to institutions.

One danger for the Fed in attempting to improve liquidity and bolster confidence is that investors could interpret the intervention as a sign that policymakers know of problems in the banking system that the broader market still remains unaware of.

In a thin week for data releases, the Bank of Japan’s meeting on Thursday is of central importance and it may fuel the view that a broader shift in monetary policy could follow the Fed’s move.

Prior to the latest bout of market turbulence, some analysts were forecasting a rise in Japanese rates at this meeting. However, any expectations that Japanese interest rates might rise from the present level of 0.5 per cent have disappeared and as inflationary pressures remain muted, investors will look for guidance on the outlook for monetary policy from the press conference.

“It will likely be difficult for the Bank of Japan to justify a rate hike,” says Kenichi Kawasaki of Lehman Brothers: “Conditions in global financial markets have turned from bad to worse and the downside risk to global growth does look larger than a month ago, to say the least. If the BoJ hikes rates no, it runs the risk of being seen to fuel market instability.”

Tuesday brings Germany’s Zew survey of economic sentiment for August with the expectations measure expected to fall sharply due to recent turbulence in financial markets. The consensus forecast for the overall measure (expectations plus current conditions) is for a fall from 10.4 in July to -2.

In the UK, the Confederation of British Industry’s Industrial Trends survey is expected to show orders and output decline. Policymakers will continue to pay attention to measures of pricing pressures developing in the manufacturing sector as the Bank of England’s latest forecasts suggest that inflation will remain above target in two year’s time.

The intial estimate for UK GDP growth in the second quarter at 3 per cent year-on-year is not expected to be revised so attention on Thursday will focus on the outlook for consumer spending which appears to be weakening.

The headline measure for US durable goods orders for July, due on Thursday, will be flattered by higher aircraft orders but the core measure (non-defence capital goods excluding aircraft) has been on a declining trend, falling 1.8 per cent year-on-year in June.