Fed cuts rates to address greater of the two evils

Fed cuts rates to address greater of the two evils

No central banker wants to have “recession" on his resume.

With that in mind, and with the odds of one rising, treasury yields tumbling, housing imploding, credit standards tightening and derivatives’ losses mounting, the Federal Reserve took bold action on Tuesday, lowering its benchmark interest rate by 50 basis points to 4.75%, the first cut in more than four years.

In a separate action, the Fed’s board of governors lowered the discount rate by 50 basis points to 5.25%, maintaining the spread between the overnight rate and the penalty rate at which depository institutions can borrow directly from the central bank for 30 days, using securities as collateral.

The rate cut was more aggressive than most economists expected. Even so, the Fed gave no indication that inflation was dead or concern about it a dead issue.

While core inflation has improved modestly this year, the Fed said in an accompanying statement that “some inflation risks remain."

So why cut rates? Isn’t inflation the numero uno concern for central bankers, an end in itself as well as a means to achieve maximum sustainable growth?

Something clearly trumped inflation: A “tightening of credit conditions," along with disruptions in financial markets, has “the potential to intensify the housing correction and restrain economic growth," the Fed said.

Too many masters

The Fed is saying that sometimes you gotta do what you gotta do, consequences be damned. Unlike the European Central Bank, the Fed has a dual mandate to foster maximum sustainable growth and stable prices. It also acts as a lender of last resort.

“In the short run, the Fed can’t do all three," said Joe Carson, chief economist at AllianceBernstein. “They have to insure the growth side. They’ll get back to inflation later."

Economic growth slowed to 1.9% in the second quarter from 3.2% in the preceding 12 months. Growth has been uneven at best, with real gross domestic product (GDP) rising 0.6% in the first quarter—close enough to zero to make central bankers nervous—before rebounding to 4% in the second. Forecasts for third quarter GDP, with yawning gaps to be filled in the monthly data, are centred in the 2-2.5% range, according to a Bloomberg News survey of 68 economists compiled earlier this month.


The vote for Tuesday’s action was unanimous, suggesting the hawkish-sounding district bank presidents were convinced they were being unduly pessimistic about inflation prospects or overly optimistic about the growth outlook. Or else they just wanted to present a united front in the first decision to cut rates with Ben Bernanke as chairman.

It will take some time for the Fed’s action to work its way through the financial system. On the most immediate level—the financial markets—the reaction was positive. Stocks soared, with the Dow Jones Industrial Average up 336 points, or 2.5%.

The risk of owning corporate bonds fell. The treasury yield curve steepened, which is par for the course when the Fed starts to ease.

Early indications on Tuesday from money broker Tullett Prebon suggested a 25-basis-point decline in three-month London interbank offered rate (Libor), which is calculated daily by the British Bankers Association in London, to 5.33%. Some big banks lowered their prime lending rate.

Bailout accusations

I wasn’t convinced the Fed would bite the bullet this month. Policy makers have been resolute in their public statements about the need to see convincing signs of a moderation in inflation before they changed their risk assessment. As recently as the 7 August meeting, Fed officials were still emphasizing inflation risks.

Following 10 days that shook the world—and the financial markets—the Fed issued an inter-meeting statement on 17 August, simultaneously cutting the discount rate by 50 basis points.

There was no mention of inflation, only an increase in the “downside risks to growth" in the face of deteriorating financial market and credit conditions. No doubt Fed officials are sensitive to criticism of bailing out borrowers and investors who made risky bets. As Bernanke himself said at the Kansas City Fed’s Jackson Hole Conference last month, “It is not the responsibility of the Federal Reserve—nor would it be appropriate—to protect lenders and investors from the consequences of their financial decisions."

Baum’s corollary

When those decisions have ripple effects through the economy at large, however, the Fed has a legitimate role to play. Once again, Bernanke said it best in that same speech.

“Developments in financial markets can have broad economic effects felt by many outside the markets, and the Federal Reserve must take those effects into account when determining policy," he said.

I like to put it another way, in what I call a corollary of the doctrine of too big to fail. If you’re going to screw up, make sure you screw up big, so that it creates systemic risk—the scariest word in a central banker’s vocabulary—and engenders a policy response.

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