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Time for the Fed to stop cutting rates

Time for the Fed to stop cutting rates
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First Published: Fri, Nov 02 2007. 12 29 AM IST
Updated: Fri, Nov 02 2007. 12 29 AM IST
The US Federal Reserve’s meeting this week must have been a tense affair. The markets were almost unanimously betting it would cut rates by a quarter-point, based on fears that the credit crunch and housing mess were bleeding into the real economy. Anticipating a cut, the dollar was swooning. Then up pops a better-than-expected third quarter gross domestic product figure—erasing a big part of the rationale for a cut.
Ben Bernanke was probably wise to shave the Fed funds rate anyway. After all, the last thing the unsettled credit markets need right now is an unpleasant surprise. The value of giving psychological relief to lenders when the markets are trying to digest—or expunge—hundreds of billions in questionable structured finance investments was worth the small risk of higher inflation—and perhaps even the bigger risk of becoming more of a slave to market expectations.
But that’s where it should stop. First, the credit markets have shown some improvement since the Fed’s half-point rate cut in September. London Interbank Offered Rate (Libor) is down almost 70 basis points, suggesting that banks are not hoarding as much capital. Investment grade and junk bond spreads have both narrowed, indicating greater investor appetite for risk.
The other big argument for easing—that it’s necessary to save the housing market—doesn’t stack up. Yes, the mortgage mess looks worse with each passing week. But that’s in large part due to the evaporation of speculative demand. It would take a massive rate cut to re-ignite that fire—and re-inflating a bubble that has already caused untold economic damage is no solution. Also, a slightly cheaper Fed funds rate isn’t likely to help subprime borrowers much when the interest on their 2-28 option adjustable-rate mortgages (ARMs) suddenly shoots up by 4-5 percentage points.
The last couple of cuts, aimed at pre-empting the worst possible outcome, were nearly justifiable. But with overall growth still apparently decent and inflation hardly quiescent, any more downward moves in rates could undermine the Fed’s credibility. Perhaps that concern prompted one Federal Open Market Committee member to vote against Wednesday’s rate cut. The credit and housing markets’ fundamental problems can’t be solved using the Fed funds rate anyway, short of a massive cut. And that would just delay an inevitable shake-out in those sectors.
The Fed should now keep its powder dry and let markets work to apportion any remaining pain.
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First Published: Fri, Nov 02 2007. 12 29 AM IST