Feds Overreacting, Cutting Rates too Much?

The Fed risks doing too much
Published: March 18 2008 19:21 Last updated: March 18 2008 19:21
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So the US Federal Reserve cut by 75 basis points rather than 100 basis points: when the numbers are big enough, a small difference between them can seem unimportant. But with rates down to 2.25 per cent, every 25bp makes a significant difference to the Fed’s brave but perilous monetary policy.
There was ample bad news for the Fed to ponder, from evidence that the real economy is now finding it harder to borrow money, to accelerating falls in house prices; from consistently weak job creation to the near failure of Bear Stearns. The Fed’s focus on reducing the danger of severe recession calls for looser policy than current inflation would normally justify, and if the Fed wants rates below 2 per cent, it is right to move there quickly.
But it is hard to escape a growing sense of disquiet about the dangers and consequences of this aggressive monetary policy. Real interest rates in the US are now negative, with rolling average headline inflation of 3.1 per cent and even core inflation of 2.3 per cent surpassing the nominal interest rate. Since the first Fed cut last September, the trade-weighted dollar has fallen by about 6 per cent, while a broad basket of commodities is up by around 19 per cent. The risk of igniting inflationary expectations is severe.
Inflation is not a problem that can be dealt with later, once recession has been staved off. If investors mistrust the Fed’s will to fight inflation, they will demand higher returns on long-dated dollar bonds, so low Fed rates might not affect the longer-term rates that mortgagors and corporations actually pay – that is, if the stressed banks are willing and able to make loans at all. The Fed was right to note that “uncertainty about the inflation outlook has increased”.
A test of the Fed’s policy is imminent. In 2001-03, a Fed Funds rate of around 2 per cent (on its way to 1 per cent) was enough to prompt waves of mortgage borrowers to refinance their loans at lower rates, which buttressed consumption. This time may be different.
In the fever and fear of malfunctioning markets, with storied institutions suddenly close to collapse, it is easy to demand too much of monetary policy. It cannot magically take back imprudent lending and deleverage hedge funds; all the Fed can do is cut interest rates to the extent that inflation risks allow. It cannot avert all recessions and should not try. The Fed does have to prop up systemically important banks and help markets – but that will take unconventional measures. Nor should the Fed rush into a quasi-fiscal bail-out – that is primarily a choice for Washington.