Hello:

The Federal Reserve (Fed) Open Market Committee (the name of their monetary policy committee) decided to cut the fed funds rate in September from 5.25% to 4.75% and to cut the discount rate from 5.75% to 5.25%. Most analysts thought that cuts were likely, but most expected a smaller quarter point cut.

Now we will likely hear from the bears that this cut likely reflects: 1) bigger problems in credit markets that we do not know about and/or 2) a Fed return to fostering higher inflation. Neither concern is, in my opinion, justified.

In a continuing careful review of daily conditions over all parts of the credit market, I find that dislocations remain pretty much confined to the lower grade, longer-term part of the commercial paper market, that some of the more egregious subprime mortgage loans are not being made anymore, that some highly levered “hedge” funds have blown up and spreads on corporate and municipal high yield debt have widened some. But that most of the credit market, CCC rated and up, is doing just fine.

Also, I do not see this rate cut as a panicky move by the Fed that will lead to a rise in inflation. Inflation has NOT been rising. In fact, core (excluding food and energy) inflation measures have been falling. The Fed’s (and my) best single measure of inflation – the core personal consumption expenditure (PCE) chain price index – has fallen to 1.9%; inside the Fed’s 1-2% “comfort zone”.

So, before the rate cut, with the fed funds rate at 5.25%, the “real” inflation adjusted interest rate was 3.35%. That is high and I view the Fed as having its foot (lightly) on the brake. This rate cut moves the foot from being lightly on the brake to neutral with a real rate at 2.85%. I think that is the right place to be.

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