Fed Time Again: 25 or 50 Bsp?

A: It's the day before the next decision on fed funds rates. Everyone gather round and huddle up. What should be done?

Arguments For 1/4 Point Rate Cut: The more likely option. Since Fed vice chairman Donald Kohn spoke a few weeks ago, the equity markets have translated his words (backed by a Bernanke speech the next day) into a rate cut induced party burning the shorts and resulting in a nice recovery after a very dangerous selloff. Now that wall street has undoubtedly 'priced in' a 1/4 point rate cut, the question is will there be any surprises?

The argument for a 1/4 point rate cut remains the same. The downside risks to the economy are clear, even though at this point in time the economic data continues to show some strength and moderating inflation; giving the fed some room to cut. Flawed or not, this is the data the fed looks at. The credit markets are still in distress, the housing market is getting worse at a faster pace, the future with ARM resets is cloudy at best (even with this gov't sponsored private sector rate freeze plan), and even Stevie Wonder can see the red flags waving that could hurt the consumer and the US economy in the months to come.

As a result, the fed will cut at least by 1/4 point to forestall the adverse effects to the economy. With pipeline inflation still a concern and the US dollar still very weak against other major currencies, the argument for a 1/4 point rate cut gets stronger. Plus, by cutting only by 1/4 point, the fed can save some ammunition for later use should things get real hairy in 2008; something that can prove to be vital to help restore some confidence without over-stimulating the economy or presenting a moral hazard for all those that made bad bets again.

Arguments For 1/2 Point Rate Cut: The main arguments for a 50 basis point rate cut is a combination of the fed being behind the curve already, the street already pricing in 1/4 point cut, and that the macro data shows a seriously slumping housing sector that will inevitably bleed into consumer spending. We know that there is a lack of liquidity in the secondary mortgage markets, but fed rate cuts do little to reverse that. We know that the credit markets are in distress, but that has to be worked out on corporate balance sheets (hey there, UBS with another $10 Billion in write downs; how are you doing?) first before normalizing.

And we also know that the housing market will get worse before it gets better and the side effects of that on the consumer, in my opinion, is the biggest argument for the fed to be aggressive and cut rates by 50 basis points.

For now, lets enjoy the free round of tequila shots that the fed has provided us via speeches by its members, as it almost makes it look like things are getting better. Beware not to confuse rate cut induced rallies for confidence & certainty returning to the marketplace. While subprime has taken all the headline blame for what is going on right now, let us NOT forget that there are plenty more loans out there that are waiting to go bad: option arms, hybrid I/O loans, cosi & cofi loans, alt-a (already starting), second mortgages, HELOC's, credit cards, and prime loans (already starting).

THIS IS NOT A SUBPRIME PROBLEM! This is a complete mortgage/lending mess that has yet to fully reveal itself and explains WHY the fed is taking aggressive proactive measures to soften the blow expected to come.

MY BET

65% ---> 1/4 point rate cut fed funds, 1/4 point rate cut discount window
30% ---> 1/2 point rate cut fed funds, 1/2 point rate cut discount window
5% ---> some combination of above
0% ---> NO CUT; that would be a shock

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