RBC Economics is calling for a Fed rate cut, driven by financial market stress, not economic fundamentals.

In a research note published today, RBC says that it has revised its outlook for the Fed funds rate, and is now calling for a 50 basis-point rate cut, “as policymakers work to alleviate liquidity concerns that have emerged in financial markets”.

“We expect the Fed to cut the Fed funds rate to 4.75% at or before the September 18 meeting, supplemented by other liquidity-enhancing measures, including possible additional changes to the discount rate and the continued injection of temporary reserves, until financing markets stabilize,” it says. “The Fed is likely to keep the amount of easing limited, however, since the aim of this policy change is to ensure that financing remains accessible rather than to bolster the pace of economic growth.”

RBC says that these measures would limit the extent of any damage to economic activity. “Our baseline assessment for growth is that the combination of tight labour markets, an easing in credit conditions and a return to stability in equity markets will limit the downside risk to the economic outlook. While the financial market fallout may curb growth in the second half of 2007, more stimulative monetary policy in the near-term makes us confident in our 2.9% real GDP forecast for 2008,” it adds.

After cutting rates to salve the markets, RBC predicts the cut will be more than reversed in 2008. “A more stimulative monetary policy will keep alive the risks that core inflation will remain above 2% for the remainder of 2007 meaning that the Fed will looking to reverse the rate cut as soon as market conditions permit,” it says.

“By the second quarter of 2008, the period of risk reassessment and high liquidity needs is expected to have passed and the Federal Reserve will be looking to reverse the easing of mid-2007. Given our view that the economy will expand at about its potential pace in 2008 and that core inflation measures will remain above 2%, we expect the Fed to shift policy to a less neutral stance, with 100 basis points of rate increases expected by the end of 2008,” RBC forecasts.

Amidst this rate action in the United States, RBC believes that the Bank of Canada will stay on the sidelines.

“Canada’s economy remains in healthy shape with second-quarter real GDP growth of 3% expected to be announced on August 31, the second consecutive quarter of above-potential growth,” it notes, adding that retail spending remains strong, labour market conditions are tight and wage growth has accelerated sharply in the past three months, and inflation remains elevated.

“Against this fundamental backdrop, the Bank of Canada would normally be raising interest rates to ensure that inflation rates fall back to the 2% target. However the significant dislocation in the short-end of Canada’s financial market and weakening in equities during the period of global financial market volatility will likely keep the Bank concentrating on keeping markets liquid so that financial market volatility does not spill over into the real side economy,” RBC predicts.

“We have shifted the timing of the next Bank of Canada rate hike in our forecast to the first quarter of 2008, a change from our previous view that the Bank would raise the policy rate by 25 basis points on September 5,” it says. “Interest rates will remain lower as investor risk aversion will result in continued buying of safer government securities. The two-year rate is forecast to end 2007 at 4.30% and the 10-year rate 4.50% (from 5.10% for both the two-year and 10-year yields in our August 1 forecast).”

“In early 2008, the economy’s strong momentum and the waning of risk aversion will see the Bank of Canada move to tighten policy, with the overnight rate forecast to rise to 5.25% in the first half of 2008 (up 75 basis points). Two-year yields are forecast to rise to 5.30% with 10-year rates peaking at around 5.45%, little changed from our previous forecast,” it concludes.