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Fed meeting - History to repeat itself? An argument for a 50bps interest rate cut
- Summary: Ben Bernanke is obsessed with history. He has spent much of his academic career studying the Great Depression, and he has often described himself as a Great Depression buff. As we will explain in this note, his aggressive 50bps rate cut at this year's September 18 meeting offers more evidence of his reliance on historical lessons. The U.S. economy is being challenged by a significant construction decline, increasing the chances of a U.S. recession. All recessions have been accompanied by construction declines, but not all construction declines resulted in recessions. In both 1967 and 1995, there were year-over-year declines in residential construction, but the U.S. escaped recessions. Bernanke obviously wants a repeat of the 1995 situation, and given his obsession with history it seems likely that he would use the 1995 Fed reaction as a blueprint for his near-term decisions. If this is the case, Bernanke may be more aggressive about cutting interest rates than markets currently expect. **Unexpected 50bps rate cut on September 18 shows that Bernanke is applying the lessons learned from history** - In August 1998 the Russian debt default and the collapse of Long Term Capital Management in America led to the same sort of financial disruption seen recently in response to the sub-prime mortgage mess. The Fed did not initially respond aggressively with cuts in interest rates, only cutting by 25bps at the September 1998 meeting. In the weeks leading up to the September 1998 meeting stock markets had an anticipatory rally, expecting a rate cut (similar to what we saw ahead of this year's September 18 meeting), but sold off when the FOMC 'only' cut by 25bps. Panic returned to markets, and two weeks later Fed chairman Greenspan was forced to call an emergency meeting and cut rates again, by another 25bps. - Some have suggested Bernanke learned from Greenspan's experience of 1998 (i.e. cut by 50bps immediately as opposed to two separate cuts of 25bps). - Bottom line: Bernanke's unexpected, aggressive 50bps rate cut at this year's September 18 meeting suggests that he relies on history to guide his decisions. **If Bernanke applies the lessons learned from history, he could be more aggressive about cutting rates than markets expect** - All recessions have been accompanied by construction declines, but not all construction declines resulted in recessions. In both 1967 and 1995, there were year-over-year declines in residential construction, but the U.S. escaped recessions. Several analysts have suggested the reason the 1995 housing slump may not have triggered a recession was that the Fed acted fairly quickly to reverse the effects of the seven Fed funds rate increases from February, 1994, through February, 1995 (6.0% from 3.0%). - Bernanke would obviously like to avoid a U.S. recession, raising the possibility that he will use the 1995 situation as a blueprint. If Bernanke tries to mimic the Fed reaction in 1995, he could cut rates by another 50bps at this week's meeting. History has shown that, in order to avoid a recession amid a construction slump, interest rates should be cut quickly and aggressively. **Bernanke is not afraid of the damage that a 50bps rate cut would do to the USD** - On October 15 he said that history suggests that price gains from a weaker dollar are small. - The weaker USD helps to offset the weakness of the housing market by boosting U.S. exports. It is possible that Bernanke would like the USD to weaken more, especially if he isn't convinced that a weak USD will lead to inflation. A 50bps would materially weaken the USD, boosting U.S. exports and limiting the impact of the housing slowdown. (by Eben Esterhuizen)
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