The Federal Reserve sets a target interbank lending rate, called the Fed funds rate, that sets the general range at which banks who house deposits with the central bank charge each other for overnight loans. Depository banks are required to keep a reserve with the central bank, typically 10% of deposits, and are penalized for failing to do so. Through the normal course of business, as banks lend and receive payments, their balances fluctuate. Banks with temporary shortfalls use this interbank lending mechanism to replenish reserves to the mandatory level.

So, how does this affect your investments?

The Federal Reserve has the power to effect this rate indirectly through the conduct of open market transactions, in which they buy and sell Treasury debt. On Tuesday, September 18th, the Federal Open Market Committee (FOMC) meets with the decision of what to do with this rate, which is currently at 5.25%.

Stock markets seem to be pricing a 50 basis point (0.5%) cut into expectations, with a nearly certain minimum cut of 25 basis points (0.25%). Speculating on Fed policy decisions is risky business. While there are certainly numerous reasons for the Fed to cut rates, there are also several great reasons not to do anything, or even raise rates.

On the cut side of the equation pressure is on for the central bank to do something to stem the subprime loan meltdown, liquidity squeeze, worsening housing slump, and recent labor market downturn. Wall Street, real estate stakeholders, and anyone interested in asset prices surely wants interest rates lower and they’re mounting pressure on Congress and the Federal Reserve.

The other side of the equation says that the dollar is being battered and will be worse off with rate cuts, inflation could take off, and bailing out markets is a great way to encourage future excesses. Many market players took outlandish risks, bidding asset prices up far beyond rational expectations. This includes subprime borrowers buying homes well outside their means with exotic adjustable-rate mortgages, wreckless lenders turning a blind eye to the capacity of borrowers to service their obligations, hedge funds, private equity, and just about everyone else reveling in the last 5 years of mulitple asset class bubbles. A government bailout either on the legislative or monetary policy sides will certainly factor into the risk models of the future!

With all that being said, we head into the next week with a great deal of uncertainty. A 0.25% cut will likely not be enough to satisfy market expectations and could even send prices lower. No cut would spell disaster for stock markets, and a deep 0.5% cut may not even have all that much of an impact considering all of the mixed economic news. It takes 3 to 9 months for a rate cut to make its effect on the economy, so the best we can hope for now is a change in investor psychology. Nonetheless, this coming week offers opportunity!

My advice is to continue with a defensive posture. The downside risk does not warrant the potential reward. Wait to see what comes out of the FOMC meeting and reassess accordingly.

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