About the US Fed Cut

10/29/08 - The Federal Reserve lowered the Federal funds rate by 50 basis points to 1% today, pointing to the deterioration in economic growth and highlighting that the "intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit."

Against the backdrop of weaker economic growth, inflation pressures are expected to moderate "to levels consistent with price stability". While the statement said that "recent policy actions, including today’s rate reduction, coordinated interest rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth," policymakers still deem that downside risks to the economic outlook persist. 

Today's statement unequivocally highlights that the Fed's focus is on the growth outlook with inflation concerns having moved to the back burner as a result of weakening commodity prices and softer growth prospects. The Fed did not close the door to further rate reductions and reiterated their commitment to "monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability."

We don't expect that the aggressive action by the Fed, with 100 basis points of rate cuts announced this month alone, will prevent the U.S. economy from slipping into recession, but we believe that it sets the groundwork for the economy to get back on a firming growth path in the second half of next year.

We look for tomorrow's GDP report to show that the U.S. economy contracted at a 0.7% annualized pace in the third quarter with a more substantial contraction in economic activity likely in the fourth quarter. The recent slide in the LIBOR rate, with the three-month rate down 140 basis points from the recent high on October 10, is providing some tentative encouragement that funding pressures are easing up although the high level of the LIBOR/OIS spread signals that markets remain nervous.

A further reduction in risk aversion and funding costs is needed before the impact of the current accommodative level of monetary policy will be able to filter through to the real-side economy. Although this is likely to take some time, we expect that the gradual improvement in credit conditions will support a moderate recovery in late 2009. Unless there are indications of a more severe weakening in near-term growth, 1% could represent a floor for the Fed funds rate.  

Dawn Desjardins, Assistant Chief Economist, RBC Economics Research. Information contained in this report has been prepared by the Economics Department of RBC Financial Group based on information obtained from sources considered to be reliable. While every effort has been made to ensure accuracy and completeness, RBC Financial Group makes no such representation or warranty, express or implied. This report is for information purposes only and does not constitute an offer to sell or a solicitation to buy securities.