With its latest interest rate cut, the Federal Reserve is saying it's worried about ongoing problems in housing and credit markets. But Wall Street appears to think central bankers aren't worried enough.
In its last meeting of the year on Tuesday, central bankers led by Chairman Ben Bernanke cut the benchmark federal funds rate by a quarter point to 4.25 percent and lowered the rate at which the Fed lends to banks, known as the discount rate, to 4.75 percent. While that was in line with economists' forecasts, the bare minimum clearly wasn't enough for investors hoping for more substantial cuts. The Dow slumped nearly 300 points. Goldman Sachs called the statement "a little stingy."
Here's five themes the Fed and investors will be pondering in the weeks to come:
The Slowdown Continues
The Fed's post-rate-cut statement acknowledged that "economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending." It also plainly noted increased strains on financial markets in the past few weeks. In short, things are worse now than they were at the Fed's last rate-cutting meeting in late October. Macroeconomic Advisors, a respected economics firm, said Tuesday that it sees U.S. growth turning negative during the fourth quarter, the first time that's happened since 2001. Morgan Stanley this week predicted a mild recession next year.
Credit Problems Remain
The last time credit markets froze up in August, the Fed cut rates by 50 basis points. Credit spreads recovered a bit, but by mid-November the freeze was back on. This time, analysts said cutting just 25 basis points and leaving the spread between the overnight and discount rates unchanged offers borrowers no new incentive to line up at the Fed's lending window. After the announcement put this round of total Fed easing at 100 basis points, the three-month dollar LIBOR rate, which normally moves down in tandem with the Fed funds rate but has traded higher owing to banks' unwillingness to lend, barely budged.
More Cuts to Come?
The Fed gave little hint that more cuts are guaranteed. While the policy statement left out a description of the risks of higher inflation versus lower growth as "roughly in balance," policy makers didn't hint which way the scales have now tipped. It seems frozen credit markets during November have now pushed policymakers back to a position of relative uncertainty. Officials left the door open for more moves, saying they'll act "as needed." Boston Fed President Eric Rosengren dissented from the Fed's decision, instead arguing for a 50-basis-point cut. In October, dissent came from Kansas City Fed Chief Thomas Hoenig against cutting rates.
Inflation still matters
With the economy slowing, the threat of spiking price pressures has abated some. But the Fed's statement once again said that "some inflation risks remain." Later this week, economists expect November's consumer price index to show a big 0.7 percent increase—that's the largest monthly jump since the mid-'90s, not counting a 2005 spike after Hurricane Katrina pounded oil production in the Gulf of Mexico.
The dollar still suffers
Lower rates mean the greenback isn't likely to come back anytime soon. While analysts are bandying about predictions for when the dollar will hit bottom, current weakness could easily be sustained well into 2008.