This morning the Federal Reserve Open Market Committee reduced its target federal funds rate by 75 basis points to 3 ½ percent. This is the largest single day cut since the Fed instituted its current procedures more than two decades ago. The only equivalent policy action was the 75 basis point increase in 15 November 1994. Not only was the Committee’s action unprecedented in size, it was taken outside of the structure of the regularly scheduled meeting.
The unusual size and timing of this morning’s policy action make one wonder. Why now rather than at the regularly scheduled meeting on 30 January? Intermeeting actions convey a sense of urgency that changes taken following scheduled meeting do not. Is this an emergency? If Chairman Bernanke and his colleagues were intent on adjusting their interest rate target between the December and January 2007 meetings why not do it earlier in the month?
A variety of possible answers to these questions comes to mind. Let me begin with the one that I believe are not correct. The FOMC did not act because the stock market was declining precipitously. A bit of background is important here. Since Monday 21 January 2008 was a national holiday in the US, stock markets were closed for a three-day weekend. Meanwhile, during their Monday and Tuesday, markets in Asia experienced severe losses. That means that the Tuesday morning scheduled open would come on the heels of the sharp declines in Asian equity markets. By 8am (Eastern US time) Tuesday morning, just before the announced interest rate cut, the futures market suggested that the New York Stock Exchange’s major indices – the Dow Jones Industrial Average and the S&P 500 index – were likely to open down more than 5 percent.
Importantly, every Fed official knows that they should not and can not cut interest rates every time the stock market falls, or threatens to fall, by 5 or 10 percent in a day or two.
Instead of focusing on high-frequency stock market gyrations, central bank officials are surely focused on the evolution of real economic activity – employment, income, sales, and the like. They are asking if current financial conditions appropriate to attain their medium-term objectives of high, stable growth and low, stable inflation. With borrowers finding it increasingly difficult to obtain funds, the answer to this has to be no. Given this, the Fed clearly had to cut interest rates.
The immediacy of the cut has its genesis in both the deterioration of macroeconomic conditions over the last week ending 18 January 2007 and the possible desire of Chairman Bernanke and his colleagues to change the Committee’s modus operandi.
Starting with the data, since the beginning of the month we have seen a very poor employment report (released on the 4 January), evidence of a fall in real retail sales (15 January), information that industrial production was unchanged in December (16 January), and confirmation of a continued precipitous decline in residential construction (17 January). Taken together, this all suggests that the US economy may already be in a recession. My own guess is that the peak in the business cycle was November 2007 and that the economy is currently shrinking, albeit modestly for now.
Meanwhile, financial market turmoil continues. While the term interbank lending market that was the source of such problems since August seems to have subsided, lenders still appear hesitant to extend credit to all but the most creditworthy borrowers. This credit crunch can only make things worse.
In response to this gathering storm, the FOMC cut interest rates four times by a total 2 percentage points in four months. Putting that into perspective, it is the same as size as the cumulative cuts from January to April of 2001, when the Greenspan Fed cut their fed funds target from 6 to 4 percent in a sequence of five actions. (Six more cuts extending to the end of 2001 ultimately brought the rate down to 1¼ percent.)
A second explanation for the timing of the cut is the possibility that this vintage of the FOMC would like to show that it can be more nimble than some people think they might be. Students of monetary policy have always found the gradualism that is so characteristic of central bank actions puzzling. If the proper interest rate instrument setting is 2 or 3 or 4 percentage points below or above the current level, why not just change it all at once? Why march along in 25 or possible 50 basis point increments? Our understanding of the impact of monetary policy on the economy, as summarized in statistical models, gives little justification for the inertia that is inherent in such a policy path.
So, here’s an alternative explanation for why the timing and size of the 75 basis point intermeeting cut in the federal funds rate target. Chairman Bernanke and his colleagues want us to know that when they see changes in the economy that compromise their medium-term stabilization objectives, they will act. They will do what needs to be done and they will do it right away.
My two explanations are not mutually exclusive. But in order to figure out if either one is correct (or some combination) we will need more information.
I should not sign off without making some comment about inflation. As discussed in my most recent inflation update, recent readings suggest that inflation is on its way up. Most forecasts that I have seen suggest the inflation trend (as measured by the Consumer Price Index) will be not be lower a year from now than it is today. That means that we are likely to enter 2009 with a CPI inflation trend of at least 2¾ percent; surely above the 2 percent most of us would like to see. Clearly, today’s actions are not directed at combating this gathering menace. Instead, for now the FOMC is forsaking its inflation objective in an attempt to keep the recession from getting worse.