Markets don't believe Fed's reluctance to keep cutting rates

By Krishna Guha and Michael Mackenzie
Financial Times, London
Friday, November 16, 2007

http://www.ft.com/cms/s/0/b311de72-947c-11dc-9aaf-0000779fd2ac.html

The risk of a collision between the Federal Reserve and the markets grew on Friday after Fed governor Randall Kroszner made it clear he believed that the US central bank was not planning to cut interest rates at its next policy meeting but was largely ignored by investors.

Kroszner said: "The downside risks to growth now appear to be roughly balanced by the upside risks to inflation." Data and information received since the Fed’s October meeting "have not changed my thinking in this regard," he added.

However, the federal funds futures market on Friday priced in a more than 80 per cent probability that the Fed would cut rates in December, while the yield on two-year Treasuries fell.

The standoff came as Hank Paulson, US Treasury secretary, kept up his increasingly vocal advocacy of the "strong dollar policy" in an apparent bid to reassure global investors that the US was not indifferent to the fate of its currency.

The Treasury secretary told reporters in South Africa that he "very much" supported a strong dollar and believed that the ­"fundamental, long-term strengths" of the US economy "will be reflected in currency markets."

The dollar, which has shown some tentative signs of stabilisation this week, rose against the yen but fell against the euro and sterling.

Mr Kroszner said that in the near term "the economy will probably go through a rough patch" with fresh falls in house prices, fewer homes being built, and subdued spending by ­consumers.

However, he said the Fed had anticipated this when it cut rates in September and October.

"Looking further ahead, the current stance of monetary policy should help the economy get through the rough patch during the next year, with growth then likely to return to its longer run sustainable rate," he said.

While Mr Kroszner formally speaks only for himself, his views are shared by many other senior Fed officials.

Peter Hooper, chief economist at Deutsche Bank securities, said he was "troubled" by the gap between what Fed officials were saying and what the market was pricing.

Vincent Reinhart, a former chief monetary economist at the Fed, said the central bank was clearly stating that it "views the risks as balanced and is reluctant to ease further."

Andrew Balls, central bank strategist at Pimco, said market participants appeared more focused than Fed policymakers on problems in the financial sector that could lead to tighter credit conditions.

Larry Meyer, a former Fed governor, said the central bank "has put itself in a box to some degree." He said credit markets had clearly deteriorated since the last Fed meeting.

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