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Sunday, October 26, 2008

Fed Funds Rate Cut

by Calculated Risk on 10/26/2008 11:42:00 AM

How much will the Fed reduce the Fed Funds rate on Wednesday? And does it matter?

First, here are the latest Fed Fund probabilities from the Cleveland Fed.

Fed Funds Probabilities Click on graph for larger image in new window.

Market participants expect a 50 bps rate cut to 1.0%, however there is some expectation of a 75 bps cut (to 0.75%).

Earlier this month, I speculated about an intermeeting rate cut: Will there be an Intermeeting Fed Rate Cut?. Sure enough the Fed cut the Fed Funds rate four days later - but market participants were disappointed with what was perceived as a feeble 50 bps effort.

Remember Bernanke wrote in 2004: What Explains the Stock Market’s Reaction to Federal Reserve Policy?

The most direct and immediate effects of monetary policy actions, such as changes in the federal funds rate, are on the financial markets; by affecting asset prices and returns, policymakers try to modify economic behavior in ways that will help to achieve their ultimate objectives.
...
The unexpected 50-basis-point intermeeting rate reductions on 3 January [2001] and 18 April [2001] were both greeted euphorically, with one-day returns of 5.3% and 4.0% respectively. The 50-basis-point rate cut on 20 March [2001] was received less enthusiastically, however. Even though the cut was more or less what the futures market had been anticipating, financial press reported that many equity market participants were “disappointed” the rate cut hadn’t been an even larger 75 basis point action. Consequently, the market lost more than 2%.
Bernanke can probably add the Oct 8th 50 bps rate cut to his list of "disappointing cuts" since the market sold off about 10% over the two days following the Fed action.

Of course the FOMC just sets the target rate. The effective Fed Funds rate has already been at or under 1% for the last couple of weeks. So the Fed will just be making this official.

And does it even matter? Probably not much at this point. But I suspect market observers will be focused on the economic outlook.

Note: Dr. Krugman is updating his book "Return of Depression Economics". I think this 1998 paper from Professor Paul on the Japanese experience might be of interest to some readers: It's BAAACK! Japan's Slump and the Return of the Liquidity Trap.