With guns blazing and surprise on its side, the Federal Reserve cut its benchmark interest rate by 75 basis points to 3.5% on Tuesday following a two-day rout in Asian and European stock markets.
US financial markets were closed on Monday for a national holiday, but with Dow futures down more than 500 points in electronic trading, the Fed had a taste of things to come when the US market reopened on Tuesday.
Now, far be it from me to imply a causal relationship between the global plunge in equity prices and the Fed’s aggressive action. But if it wasn’t the stock market, what else impelled Fed policymakers to take emergency action one week before a regularly scheduled meeting?
Tuesday’s cut is both the biggest since the Fed started targeting the overnight rate in the mid-1980s and the closest to a meeting, according to Tom Gallagher and Andy Laperriere of the ISI Group in Washington.
In a statement, the Fed said it took action “in view of a weakening of the economic outlook and increasing downside risks to growth”. (Translation: We changed our forecast, and the odds of going down are going up.) The Fed’s stable of economists must have noticed the increased odds of a slump as reflected in the “US Recession ’08” contract on Intrade.com, an online site where individuals can bet on financial markets and current events. The contract, which will pay $10 (Rs396) if the US goes into recession this year, traded at a lifetime high of $7.75 on Tuesday.
The Fed cited additional reasons for its action, none of which will disabuse observers of the notion that the stock market forced its hand.
No new news
“Broader financial market conditions have continued to deteriorate,” the Fed said, even in the face of an improvement in short-term financing markets.
A worldwide stock market rout would definitely qualify as “broad”. Then there was the reference to “a deepening of the housing contraction as well as some softening in labour markets.”
Why wait until now? The 0.3 percentage point increase in the unemployment rate to 5% was reported on 4 January. The number of people filing weekly for unemployment benefits fell dramatically in the last three weeks from 357,000 to 301,000. There was nothing new and negative on the employment front to tip the Fed’s hand.
What about housing? Residential investment has been in decline for two years, with no real end in sight. Last week’s news that housing starts (an economic indicator that represents the beginning of construction of new privately-owned homes) fell 14.2% in December from the previous month to a 17-year low was horrendous on the surface, but it’s a step in the right direction of slashing the inventory overhang.
Guilt by omission
“Appreciable downside risks remain,” the Fed said, concluding its statement with a promise to “act in a timely manner as needed to address those risks.”
What the Fed lacked in timing—policymakers were seriously behind the curve—it tried to make up for in size. Both economists and traders, whose bets are reflected in the Fed funds futures markets, expect an additional 50 basis points at next week’s meeting.
In the communications department, it was just plain “disingenuous” for the Fed not to mention “falling financial markets”, the ISI economists said in a note to clients.
Perhaps the Fed wanted to avoid the invective of consumer advocacy groups. More US households own homes (68.2% in the third quarter of 2007) than equities (50% of households, according to the Investment Company Institute), either outright, through mutual funds or in 401(k) accounts (a type of employer-sponsored retirement plan in the US).
Yet the Fed didn’t feel compelled to bail out the housing market last year, when lower interest rates could have assuaged expectations of subprime mortgage defaults, which ricocheted through the market for collateralized debt obligations, delivering $133 billion in credit losses and writedowns to financial institutions.
Households had almost twice as much of their net worth in real estate as stocks as of the third quarter of 2007, according to the Fed’s Flow of Funds report.
The argument against creating a moral hazard, or encouraging risky behaviour through insurance, seems to have gone out the window in light of the two-day rout in Asian stock markets. Hong Kong’s Hang Seng index plunged 13.7%. Japan’s Nikkei fell 9.3%, its biggest two-day loss in 17 years. India’s Sensex was off 12%. And China’s stock market posted its biggest two-day decline (12.2%) on record.
In the US, the Standard and Poor’s 500 index is off to its worst start ever in a new year. With the dive in overseas bourses this week, it looks like “decoupling”—the idea that the rest of the world could separate itself from economic events in the US—has gone the way of “containment”, the notion that the subprime mess was a niche issue.
Congress, which has oversight of the Fed, is apt to question Bernanke not so much about what he did, but when he did it.
“Accommodative is not when short rates are above long rates,” said Jim Glassman, senior US economist at JPMorgan Chase & Co. “It’s too bad the Fed didn’t do this until the market twisted its arm.”
It turns out the Greenspan put didn’t follow the former Fed chief to the private sector. It may yet prove to be his most lasting legacy.
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