The financial markets expect a rate cut from the Fed at the September 18 policy committee meeting.  Stock traders view a rate cut as warranted.  From the Fed's point of view, however, a rate cut may not be necessary.  The macro-economic data trends are just fine.

Rate Cut Expectations

Fed funds futures trade at a price that assumes the Fed will lower the funds rate target to 5% from the current 5 1/4% at the September 18 FOMC policy committee meeting.

Furthermore, fed funds futures also assume another rate cut of 1/4% at or before the October 31 meeting, and yet another 1/4% cut at the December 11 meeting.  Fed funds futures trade at a level that assumes a 4 1/2% fed funds rate in January. 

These expectations are overdone.  It would not be the first time.  The fed funds futures have priced in expectations of a rate cut many times since the Fed last raised the fed funds target on June 29, 2006.  The Fed has been content to simply hold policy steady for well over a year.  They may keep that up until they get what they want - some slackening in resource utilization.

A Rate Cut is Certainly Plausible

From the financial markets perspective, a cut in interest rates is fully justified.  The liquidity problems on Wall Street are the overriding factor in this argument. 

Inflation and economic data can be used to support this argument.

Most significantly, inflationary pressures have eased recently.  The core PCE deflator has risen at just a 1.6% annual rate the past six months.  There have been two 0.2% monthly increases and four 0.1% gains in that period.  This low inflation rate has brought the year-over-year increase in the Fed's favorite inflation measure down to just 1.9%.

If the Fed felt a rate cut was needed to address either the liquidity problems on Wall Street or a significant slowdown in the economy, the inflation data won't prevent them from acting.

The View from the Fed

But from the Fed's point of view, that doesn't mandate a rate cut.

The Fed stated in their August 7 minutes that while the recent trend in inflation has been good, "a sustained moderation in inflation pressures has yet to be convincingly demonstrated." 

The main reason that the Fed feels inflationary pressures could pick up again is that "the high level of resource utilization has the potential to sustain those (inflation) pressures."  This refers to the fact that the labor market remains tight, as reflected in a low unemployment rate, and that wage gains could pick up as a result.  That could in turn push prices higher.

As the minutes noted at the conclusion of the paragraph on inflation trends, "The employment cost index rose somewhat faster in the second quarter than over the preceding three months, and the twelve-month change was slightly higher than a year ago."

In other words, the fight against inflation will continue until resource utilization eases in the labor market and reduces the recent upward pressure on wages. It is unlikely that this macro-economic view has changed in the past month because of the liquidity problems in the credit markets.

The Overall Economy Remains on Track

The other argument for a rate cut comes from the concern that the problems in the subprime mortgage market will lead to broader weakness in the economy.

There simply is no evidence yet that this will be the case.

There is no denying that the housing market remains in a deep slump.  The Fed recognizes this and Bernanke has even noted that conditions might get worse before they get better.  But the broader economic data remain on track.

Most importantly, consumer spending continues to rise at a moderate pace.  July personal spending, released Friday, rose 0.4%.  This is the broadest measure of consumer spending.  It also was up 0.2% in June, and 0.6% in April and May.  Spending has risen at over a 5% rate the past six months (slightly less than 2% when adjusted for inflation).  There is no indication of a significant slowdown in any of the consumer spending data. 

Business investment also shows no slowdown in recent months.  Nonresidential investment rose at an 11.1% annual rate in the second quarter.  That included a 27.7% rate of increase for nonresidential structures (mostly commercial buildings), but also a 4.3% rate of increase in software and equipment on the part of businesses.  

Both consumers and business continue to spend.  The housing slump has remained an isolated problem.  As a result, forecasts for third and fourth quarter real GDP growth remain centered in the 2% to 2 3/4% range.  That is very much in line with Fed desires - slightly lower than long-term potential growth which allows for an easing in resource utilization and inflationary pressures without recession. 

What it All Means

The Fed has the rationale to cut rates if they chose to do so.  Inflation has eased and economic growth is sluggish.

But the macro-economic data do not necessitate a rate cut.  In fact, real GDP growth trends in the second half of the year appear little changed from the first half of the year.  There is no discernable impact from the liquidity crunch on Wall Street. 

The Fed has made it clear that they are not ready to declare victory in the fight against inflation.  The underlying inflationary pressures from high resource utilization created by strong economic conditions in 2003-2005 have not yet been reversed.  So long as possible, the Fed will maintain high interest rates in order to keep real GDP growth slightly below 3%.  That, in their view, will bring down long-term inflation pressures.

The financial markets have guessed wrong a number of times in the past when rate cut expectations arose because of weakness in the housing market.  The Fed didn't blink then, and they might not blink now.

The liquidity problems on Wall Street certainly concern the Fed, but providing liquidity rather than lowering interest rates is the best way to combat that problem.  It must also be remembered that the Fed felt liquidity was excessive earlier this year when lending for takeovers and mortgages was booming.  Having the market correct for that is always going to create some problems that the Fed is willing to accept.

The Fed also has made it clear that they stand ready to lower interest rates if necessary.  That is, if the macro-economic data do suddenly take a turn for the worse.  The simple fact is, however, that while stock traders may worry about that happening, it simply has not yet occurred.

The S&P 500 index is up 4% on the year.  Second quarter real GDP was up a 4.0% annual rate.  Consumer spending and business investment continue to grow at a moderate pace.  Market mechanisms are correcting for the excessive liquidity conditions of earlier this year.  Monthly inflationary numbers are down.

From the Fed's point of view, these are not conditions that call for panic.  In fact, the script is playing out very much as the Fed wants.

One or more rate cuts may well happen, but are by no means certain.