The Short View: Fed’s priority

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Markets are generating enough uncertainty of their own, but they now face external events that could stoke up volatility. Friday brings US non-farm payrolls, which almost always provoke a market overreaction. On Tuesday, the Federal Open Market Committee meets for the first time since world credit markets started to tumble. The FOMC’s statement also regularly provokes a wild overreaction.

Nobody expects the Fed to change the Funds rate next week. It will stay at 5.25 per cent. But the market does now believe the Fed will cut rates by the end of the year. Fed Funds futures put the chance of a cut to 5 per cent by January at almost 100 per cent.

Meanwhile, the market seems unconcerned about inflation. Treasury inflation-protected securities imply an inflation rate of 2.09 per cent over the next five years. This has fallen in recent weeks.

But a more benign view of inflation is unlikely on its own to induce the Fed to cut. That would require evidence of rising unemployment, which the payroll data may not provide.

Rather, the most likely cause for a cut would be to bail out the market from its subprime problems, as Alan Greenspan did with two rate cuts in the wake of the Long-Term Capital Management crisis in 1998.

The Fed may start preparing the way for a cut next week. But that seems unlikely.

A better guess is that it will follow a template set yesterday by Jean-Claude Trichet, president of the European Central Bank. The ECB made it clear it remained hawkish on inflation. As for the turmoil in the markets, it said it “deserved attention”, but that it signified a “process of normalisation”.

The message was that the ECB was worried by the markets, but for the time being felt the process would not be harmful, and that the fight against inflation should still take priority.

It may disappoint the markets, but the Fed’s message may be much the same.

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