Fed rate- who calls the shots?

The U.S Federal fund rate is the rate that banks charge each other for overnight loans of Federal funds which are the reserves held by banks at the Fed. This rate is about 3% lower than the prime lending rate. Any change in the Fed rate will have direct implication on the lending rate to consumers & corporate & a bearing on the economic activity & inflation.

The FOMC(Federal open market committee) headed by the Fed reserve chairman is empowered to do the Fed rate change. But recent happenings in the U.S stock markets makes one to believe that the capital market has a profound influence in the decision making process of the FOMC. The markets factor the rate cut ahead of time & keeps climbing up leaving virtually a "Hobson's choice" for the FOMC.

Take the example of the October 31st, 2007 FOMC meet. The data showed inflation was at comfort level with less than 2%, economy grew by 3% for the quarter( the highest for the year), labour figures were healthy. Of course the sub prime mess & credit problems were a concern. But having made a 50 basis point cut in their September meet & given the economic data, one would have thought that the rate would be left unchanged. But in reality, the FOMC made a 25 basis point cut. The Fed in their beige book comments recorded that the decision to cut rates was a "close call". One can only surmise & read between the lines that the Fed played the balancing act. After all this, the market which had gone up prior to the Fed meet, tanked in November with news of more write offs from Citi group & other credit problems.

That brings us to the main topic- Who calls the shots?- the Fed or the stock market influencing the decision. Had the Fed left the rate unchanged in October, they could have probably left their reputation intact. The Fed's main aim is to promote economic growth & control inflation thro' monetary policies. Stock markets are a measure of economy & not the economy itself.

In defence of the Fed, one can say that they are in an unenviable situation. Should their decision precipitate a fall in the market, it is not confined to just the U.S market but has a cascading effect on the global markets. The fallout is huge & that always weighs in the decision making process. The pressures are enormous but as they say " when the going gets tough, the tough gets going". That's what separates the great from the good.