Parsing the Fed (April 30, 2008 Edition)

The Federal Open Market Committee cut the Fed Funds Rate by 0.250 percent today.  The Fed Funds Rate is now 2.000% after the FOMC's seventh cut in eight months.

Normally, a cut in the Fed Funds Rate pushes mortgage rates higher.  So far, though, mortgage rates appear to be improving.  This is because the Fed's language hinted that the rate cuts may be over -- at least temporarily.

A "pause" puts focus on the Fool in the Shower theory.  It's something we've talked about before but if you don't feel like revisiting the concept in all of its glory, here's a summary:

The Federal Reserve's job is control the heat of the economy and one tool at its disposal is the Fed Funds Rate.  Lowering the Fed Funds Rate heats the economy towards inflation and raising the Fed Funds Rate cools it towards recession.

It's similar to taking the first shower in your home in each morning.  The water is usually freezing so you turn the knob all the way up to hot.  But then, the water gets too hot so you have to dial it back a bit.

The FOMC press release faintly signals that the Federal Reserve may start "dialing it back" a bit because of a stabilization in the economy and rising inflation.  Food and energy prices are very high, for example, and may threaten a business-led recovery.

In shower terms, the "economy water" is getting too hot.

Markets are interpreting the FOMC's press release to mean that future rate cuts are not a given, and that rate hikes could happen later this year.  That strengthens the U.S. dollar and reduces the impact of inflation -- two things that lead mortgage rates lower.

This is why mortgage rates are down thus far this afternoon.  Traders are changing their bets against the future of the U.S. economy and mortgage bonds are one of the beneficiaries.

The Fed's next scheduled meeting is June 28-29, 2008 -- that's a long two months from now.  If the shower water gets too hot or too cold in the meanwhile, it's likely that the FOMC's will meet in emergency to take action.

Source
Parsing The Fed Statement
The Wall Street Journal Online
March 18, 2008
http://online.wsj.com/internal/mdc/info-fedparse0804.html