The stock market was surprised and shocked yesterday to learn that the Fed wasn’t cutting interest rates. The initial reaction to the news of standing pat with Fed funds: sell first and ask questions later. But the surprise and shock was fleeting, and investors did a volte face and decided that holding rates steady was the best course after all. Buyers proceeded to bid prices up.
The net effect was that the stock market was on a roller coaster yesterday even though the central bank continued its long-standing policy of sitting on its hands, as defined by Fed funds, which still stands at 5.25%. For those who watch Fed funds futures for clues, yesterday’s news of letting it ride was a yawn. The futures market has long anticipated that 5.25% would remain the standard.
But if futures prices can be trusted, a cut of 25 basis points to 5.0% is coming by late this year or early in ’08. One school of thought thinks a cut makes sense in part because of the current credit crunch that’s thrown the capital markets into a tizzy. But while the Fed has a history of coming to the rescue in times of liquidity squeezes, there’s reason to wonder if erring on the side of monetary caution remains the better choice at this juncture. The credit crunch for the time being isn’t all that crunchy. Liquidity has dried up some, but that’s only relative to the recent levels of excess. In any case, so far there’s still lots of cash looking for a home in the global markets.