Monetary policy: Desperate measures

A whiff of panic as the Fed cuts rates

THE Federal Reserve slashed its benchmark interest rate by three-quarters of a percentage point to 3.5% on Tuesday January 22nd. The decision came at an unscheduled policy meeting—the next planned one was due on January 29th and 30th, when it was widely expected to reduce rates by half a percentage point. With global stockmarkets in freefall, the Fed instead decided that a bigger cut was needed—and sooner. A week may be a long time in politics, but waiting eight days to cut rates would, it seems, have been an intolerable stretch for financial markets.

The deepening gloom about the economy may well warrant such an aggressive response. But the timing is puzzling. There is more than a whiff of panic about slashing rates little more than week before a scheduled meeting. The Fed statement issued with the decision rationalises the cut as a response to “downside risks to growth”—the phrase is repeated twice in six short paragraphs—and cites recent gloomy data on housing and jobs. Yet the economic news has not grown any worse in the past few days and, given the time needed before monetary policy affects spending, the added urgency seems odd.

What has shifted for the worse is financial-market sentiment. It is hard not to conclude that the Fed has acted to shore up markets, which have switched to panic mode alarmingly quickly over the past week. The Fed noted—it could hardly fail to do so—that “financial market conditions have continued to deteriorate”. But if concerns of further stockmarket damage was its main motivation the cut did little to prevent a big sell-off on Wall Street. The Dow Jones Industrial Average fell over 400 points when it opened shortly after the Fed's announcement: not much less than the fall that was priced in before the Fed acted.

If the markets failed to view looser monetary policy as a nice surprise, that was understandable. In his short tenure the Fed’s chairman, Ben Bernanke, has only used scheduled meetings to make changes to the Fed’s main policy rate. That he was moved to act just a week before one will raise the suspicion that the Fed knows something that markets don’t. Nor is it only the timing that is troubling. The size of the cut also brings more fear than comfort. Even the Fed under Alan Greenspan, which cut rates from 6.5% to 1% in the early years of the decade, was never moved to cut by more than half a percentage point in a single go.

Only one voice dissented on the Fed’s rate-setting committee. William Poole voted against the cut, arguing that things were not sufficiently bad to warrant action so close to a regular meeting. That no one else was swayed by that argument suggests that the bulk of the committee is now either very worried about the economic outlook or that there was a serious risk of financial-market meltdown. Concerns about inflation, which the Fed expects to moderate, have been relegated almost to an afterthought.

The meeting at the end of the month is still expected to go ahead and it seems unlikely that the Fed’s committee will convene only to sit on its hands. Futures markets are pricing in a further quarter-point cut on January 30th. Presumably the markets can manage to hold on until then.

From Economist.com