FOMC Minutes for Sept 18, 2007

The Fed released the minutes of their Sept 18th FOMC meeting, detailing their decision to lower the Fed funds rate by 50bps. Let's start at the end:

"Members judged that a lowering of the target funds rate was appropriate to help offset the effects of tighter financial conditions on the economic outlook. Without such policy action, members saw a risk that tightening credit conditions and an intensifying housing correction would lead to significant broader weakness in output and employment. ... In order to help forestall some of the adverse effects on the economy that might otherwise arise, all members agreed that a rate cut of 50 basis points at this meeting was the most prudent course of action."

Three thing to make note of: First, all members favored cutting 50 bps, including the non-voters. That matters because four regional Fed voters will rotate in January. Second, their main worry is that weakness in housing will be intensified by tighter mortgage market conditions, and that will feed into broader economic weakness. That's important at least as much for what they're not saying, namely that they're not primarily concerned with current growth, employment, inflation etc. Third, they don't expect the 50 bp cut to fully counter the deterioration in the economic outlook.

Now on to the details. Here's how they described the economic environment immediately prior to cutting 50bps:

"...to date, initial claims for unemployment insurance did not indicate a substantial and widespread weakening in labor demand, and labor markets across the country generally remained fairly tight"

"...some recent data and anecdotal information pointed to a possible nascent slowdown in the pace of expansion."

"...financial conditions confronting most nonfinancial businesses did not appear to have tightened appreciably"

"Participants reported that recent financial market developments generally appeared to have had limited effects to date on business capital spending plans and expected that business investment was likely to remain healthy in coming quarters."

"...participants noted that foreign demand remained robust and net exports appeared strong."

That couldn't be clearer: current growth isn't really a problem, certainly not enough to justify their 50 bp cut.

The Fed really does mean it when they say they respond to changes in the outlook for growth and inflation. On the inflation outlook:

"Incoming data on consumer price inflation ...in combination with the easing of pressures on resource utilization in the current forecast, led the staff to trim slightly its forecast for core PCE inflation."

"Headline PCE inflation ... was expected to slow in 2008 and 2009."

"...they generally were a little more confident that the decline in inflation earlier this year would be sustained."

"They also agreed that the inflation situation seemed to have improved slightly and judged that it was no longer appropriate to indicate that a sustained moderation in inflation pressures had yet to be shown."

Again, the message is pretty clear: inflation isn't the central concern. Now on to the growth outlook:

"...the staff marked down the fourth-quarter forecast ... [and] also trimmed its forecast of real GDP growth in 2008"

"...participants judged that credit markets were likely to restrain economic growth in the period ahead."

"...meeting participants focused on the potential for recent credit market developments to restrain aggregate demand in coming quarters."

"...participants judged that some further slowing of employment growth was likely."

"...a further tightening of terms for home equity lines of credit and second mortgages seemed possible, which could weigh on consumer spending, especially for consumer durables."

Ok, now we're getting somewhere. Growth is expected to be below potential through 2008, largely due to problems in credit markets.

So the forecast is for lower inflation and below potential growth through 2008. The only missing piece is the balance of risks for that forecast:

"...participants regarded the outlook for economic activity as characterized by particularly high uncertainty, with the risks to growth skewed to the downside."

"Some participants cited concerns that a weaker economy could lead to a further tightening of financial conditions, which in turn could reinforce the economic slowdown."

"The disruptions to the market for nonconforming mortgages were likely to reduce further the demand for housing"

"...subprime mortgages remained essentially unavailable, little activity was evident in the markets for other nonprime mortgages, and prime jumbo mortgage borrowers faced higher rates and tighter lending standards."

"...if declines in house prices were to damp consumption, that could feed back on employment and income, exerting additional restraint on the demand for housing."

Ouch. Not only do they see downside risks to their growth forecast, but they see the potential for those downside risks to snowball into even greater downside risks. No wonder the 50bp cut was unanimous.

In response, the Fed funds futures markets priced in significantly lower odds of a rate cute this year. Here are the odds for the Oct 31 meeting outcome, before and after the release of the minutes:

I think the market has got it wrong; more cuts are coming.