Wednesday, March 19, 2008

The Fed risks doing too much

(FT Editorial) 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.

But FT's Lex column opines:

No sugar coating there. The Federal Reserve was frank about the toxic conditions it faces as it cut rates another 75 basis points. “The outlook for economic activity has weakened further”, financial markets remain under “considerable stress”, “uncertainty about the inflation outlook has increased”. On top of that, there is growing disagreement within the open market committee – two members voted for smaller cuts.

The Fed has now taken real interest rates negative to the tune of 1.75 per cent, given headline inflation of 4 per cent. The last time that happened, in 2003 and 2004, it triggered a borrowing binge that left us with today’s mess. This time, the Fed is finding it far harder to kick-start the system.

Financial markets remain dislocated by falling prices on illiquid assets, declining leverage and financial stress at big institutions. That means rate cuts have not been transmitted easily through to companies and individuals borrowing money. Credit spreads have widened and overburdened banks have pulled back on providing credit.

The Fed’s extreme measures of recent days – giving investment banks direct access to the discount window and guaranteeing $30bn of illiquid Bear Stearns assets to facilitate the takeover by JPMorgan – should help repair that plumbing somewhat. But rate cuts will still take time to feed through. And the central bank is in a hurry to have an impact before credit turmoil weakens housing and the real economy even further. That could cause a negative feedback loop in the banking system by increasing bad debts.

The Fed is, rightly, taking a risk on unintended consequences. Getting too aggressive in its actions risks triggering a further dollar collapse or fuelling inflation fears. But perhaps some healthy dissent on the committee, to remind the most gung-ho members of the central bank’s dual mandate on growth and inflation, is no bad thing.

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