Fed must walk a thin line on rates
Has the Federal Reserve painted itself into a corner?
That’s one question on investors’ minds as central bank officials convene for a two-day meeting today to consider a further interest rate cut. The session comes as the Fed tries to walk a monetary tightrope: attempting to address concerns that the U.S. economy may be tipping into a recession without looking as if it is being pushed by panicky stock-market traders to take steps that could promote inflation.
The Fed has reduced its benchmark rate by 1.75 percentage points since Sept. 18 in an effort to relieve a credit crunch that threatens economic growth. The latest cut, a hefty three-quarters of a point, was an emergency measure last week that followed a steep fall in Asian and European stock markets that threatened to spread to the U.S.
The move succeeded in calming Wall Street, and U.S. stock markets turned in their best weekly performance of the year. Stock prices in the U.S. climbed again Monday, with the Dow Jones industrial average gaining 176.72 points, or 1.4%, to 12,383.89. The broader Standard & Poor’s 500 index jumped 1.8%.
Yet after months of market watchers complaining that the Fed and its chairman, Ben S. Bernanke, were moving too slowly to respond to the credit crisis, the talk now is that the emergency cut suggests that the Fed has caught a whiff of panic itself.
The talk grew louder after the disclosure Thursday of a $7-billion trading scandal at France’s second-biggest bank, Societe Generale. The bank’s unwinding of equity futures positions allegedly accumulated by a rogue trader arguably exacerbated the plunge in European markets Jan. 21, the day before the Fed’s emergency rate cut.
In a statement Thursday, the Federal Reserve said it had been unaware of Societe Generale’s losses when it took action. But that statement artfully avoided the real issue: whether the central bank responded to a European market dive that seemed genuine but had been artificially worsened by the French bank’s large-scale selling.
Some economists say that to preserve its reputation for steadfast independence, the Fed should back off from its aggressive rate-cutting stance this week.
“The Fed has to show that they are not panicking and they are not being forced by markets to decide the path for monetary policy,” said Kenneth Kim, an economist with Stone & McCarthy Research in Princeton, N.J.
Trading in interest rate futures Monday suggested an 86% chance that a half-point cut in the fed funds rate, to 3%, will be announced Wednesday -- and no doubt that there will be at least a quarter-point reduction. There is some question whether the stock market would be content with a quarter-point cut or would decline sharply.
“They shouldn’t do as much as the market wants,” said veteran Fed watcher David M. Jones, senior economic advisor to Mizuho Securities USA. “If you start giving in to the market, there will never be enough for them.”
Jones said the Fed should ease by no more than a quarter-point and preferably stand pat. “It would be best after this very strong move to demonstrate that they will cut on their own terms, not on the market’s terms,” he said.
Even a quarter-point cut, coupled with last week’s action, would mean a reduction of a full percentage point in an eight-day period, marking the fastest easing by the Fed since 1982. Typically, the central bank takes at least three or four months to bring rates down that much, so it has time to gauge the effects.
Under normal circumstances, some economists say, any cut from the current level would carry a sizable risk of a surge in inflation several months from now. With inflation currently running at 2% to 3% a year, the real federal funds rate -- that is, adjusted for inflation -- is close to zero. A further cut could turn it negative.
“When the Fed’s gone into negative real interest rate territory, that’s stoked inflation fears down the line,” said Marvin Goodfriend, a professor of economics at Carnegie Mellon University’s Tepper School of Business and a former Fed economist.
Nonetheless, Goodfriend said, recession fears today could easily lead the Fed to adopt an overly loose monetary policy. “The hardest job for a central bank is not succumbing to temptation to revive the economy prematurely with negative rates,” he said.
The economic environment is different today from the 1990s, however, because of the perceived threat to growth from the sub-prime mortgage collapse. Sales of new homes plummeted a record 26.4% last year, the Commerce Department said Monday.
Meanwhile, banks worried about whether their capital cushions are adequate, given questions about the quality of their mortgage holdings, are still wary of lending -- an attitude that could put sand in the gears of economic growth. That could be a stronger influence on the Fed than fear of being seen as a cat’s paw for Wall Street.
“The Fed really is worried about a classic credit crunch, when nobody knows how to value anything,” said James D. Hamilton, a professor of economics at UC San Diego. Lowering rates, he said, “will help the problem even if it doesn’t solve it.”
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maura.reynolds@latimes.com
