The Fed finally acknowledged today the risk of a serious US economic slowdown given the current financial and credit markets turmoil. More important than the symbolic 50bps cut in the discount rate was the move – in today’s FOMC statement – from the semi-neutral bias of the last few months ("semi" as inflation was still their predominant concern until recently) to a clear easing bias today. Essentially today the Fed telegraphed a certain Fed Funds rate cut at the September meeting and possibly more cuts in the months ahead.  

The statement was very clear in signaling an easing bias and a policy cut ahead: “Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth forward."  The statement also pointed that "the downside risks to growth have increased appreciably". And it clearly signaled that the FOMC is "prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets."
 

The stress on the downside risks to growth and the failure of the statement to even mention the “I” word (Inflation) suggests that, in about a week since the previous FOMC meeting, concerns about inflations as the predominant risk have faded and concerns about growth have sharply increased. For a Fed that – until recently – was in the soft landing camp (slowdown of growth but still moderate pace of growth) today’s statement is a signal that they are starting to worry about a hard landing of the economy.  For the first time in over a year the Fed is now implicitly admitting that they underestimated the downside growth risk: until now the official Fed view was that the housing recession was contained and bottoming out and not spilling over to other sectors of the economy; and that the sub-prime problems were also a niche and contained problem. The sudden shift to a strong easing bias suggests that the Fed miscalculated until now the damage to the economy and to financial markets of the housing recession and its real and financial spillovers.
 

Even before this tightening in financial conditions following the recent market turmoil economic growth was weakening: a deepening housing recession; a saving-less and debt-burdened US consumer buffeted by many shocks (high oil and gasoline prices, falling home values, falling home equity withdrawal, slackening labor markets, tightening mortgage markets) and slowing down its consumption to 1.3% in Q2 (and further down in August based on the most recent data); a corporate sector on a real investment strike (with capex spending on  software and equipment growing a dismal 2.3% in Q2).
 

Now with financial conditions significantly tightening in credit and financial markets the shock to private consumption, real capex investment of the corporate sector, and residential investment will be even more severe, thus increasing the risks of a US hard landing (either a growth recession with growth below 1% or an outright recession). You have the beginning of a severe credit crunch in mortgage markets (not just sub-prime but also near prime and prime mortgages) and in consumer credit (especially non-credit card consumer debt); a severe tightening of credit conditions for anything related to real estate (housing, non residential real estate) and mortgages; and a sharp increase in credit spreads for the corporate sector that will push down corporate capex spending. Add to all this rising risk aversion, panic, fall in consumers, corporate, investors’ confidence that are important drivers of durable and capital spending decisions and you have all the conditions for a US hard landing.
 

Will the Fed be able to rescue the economy and avoid the hard landing? This is quite unlikely in my view.
 

First, as argued here before we are facing an insolvency crisis for many agents in the economy, not just a liquidity crunch. Given the serious insolvency - rather than just illiquidity-  among many economic agents (many mortgage-burdened households, dozens of mortgage lenders, many homebuilders, some hedge funds and financial institutions, some distressed corporates) a modest Fed easing in the fall – even a likely 75bps cumulative cut by December - will not make much of the difference as you cannot solve an insolvency problem by throwing liquidity at it. The de-leveraging of a massive Minskian credit bubble has barely started and easy money will not be able to reverse this credit downturn. This is a much more serious credit crisis and crunch than the liquidity crunch around the LTCM near collapse in 1998.
 

Second, even the currently prices Fed rate cuts will not be able to restore normal conditions in credit and financial markets given the widespread uncertainty about the losses from subprime and other mortgages and given the uncertainty about which institutions are at risk. Equity markets have moderately rallied today but the credit crunch in highly illiquid instruments will remain and keep markets and investors on the hedge. And news of further downgrades, delinquencies, insolvencies and stresses in pockets of markets and in financial institutions will keep investors highly nervous and risk averse.
 

Third, the economic slowdown is already underway and given the glut of housing, autos and durable goods in the economy the demand for these goods will be relatively insensitive to interest rates. In 2001 and on the Fed aggressively cut the Fed Funds rate, from 6.5% to 1% by 2004; and long rates fell by 200bps in that period; still the 2001 recession was not avoided given the then glut of tech capital goods and real investment fell by 4% of GDP between 2000 and 2004. Once there is a glut of capital goods – then tech good, today housing, autos and consumer durables – Fed easing is like pushing on a string and becomes less effective as it takes time to work out such a glut. 
 

Thus, at this point what the Fed will do in the next few weeks and months may be too little too late to prevent a US hard landing.