Tuesday, 18 March 2008

Only 0.75 percent

Some immediate reactions to the FOMC's statement.....

The Federal Open Market Committee decided today to lower its target for the federal funds rate 75 basis points to 2-1/4 percent.

That is how mad monetary policy has become in the US. The Fed only cuts by 0.75 percent when everyone was expecting a full one percent cut. The Fed is behaving "moderately" bringing rates down to 2.25 percent.

Recent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters.

The R-word is so hard to say. The FOMC can go no further than "Recent information indicates that the outlook for economic activity has weakened further".

Nevertheless, the Fed's faith in interest rate cuts is almost comical. The US is almost certainly already in a recession; its banking sector is probably insolvent; its currency is collapsing; real interest rates are negative; the current account is huge and is dependent on emerging market economies for external financing; the private sector is overloaded with debt; the fiscal deficit is rising quickly and a further expansion of public sector debt is planned for later this year; inflation is increasing, wage growth is stagnant; and the housing market in in meltdown.

So a 0.75 cut is the answer to this mess. I'll be honest here, I am doubtful.

Inflation has been elevated, and some indicators of inflation expectations have risen. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook has increased. It will be necessary to continue to monitor inflation developments carefully.

On inflation, the FOMC goes for the usual understatement and complacency; inflation is only "elevated". On commodity prices, the Fed thinks that everything will level out. Why would they think that?

With the dollar sliding, commodity prices going through the roof, and the Fed cutting rates, it is hard to see how the economy can keep growing and inflation will fall - all at the same time.

Here is the fundamental contradiction in Fed policy. On the one hand, it is saying the cuts are needed to maintain economic growth. On the other, it is saying it expects inflation to decline. It can all be squared away only if you think that the Fed is being disingenuous about growth; that it has written off any prospect of avoiding a recession; and that its real concern is avoiding a systemic banking failure. In those circumstances, inflation will take care of itself as the recession takes hold and unemployment rises.

It all points to the policy ineffectiveness of the Fed right now. The econony is now adjusting regardless of what the Fed does or says. The comments on inflation speak of this impotence. When it comes to price stability, the Fed doesn't have a strategy other than "monitoring" inflation. Unfortunately, no price ever came down because it was being watched.

Today’s policy action, combined with those taken earlier, including measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity. However, downside risks to growth remain. The Committee will act in a timely manner as needed to promote sustainable economic growth and price stability.

Here is where we get to the truth.

This cut is about the banking sector. The fed thinks low rates promotes liquidity. That remains to be seen.

However, the final sentence in the statement is the scary one - "The Committee will act in a timely manner as needed to promote sustainable economic growth and price stability." There isn't much left in terms of monetary policy maneuverability. Rates are now and 2.25 percent. They can't go much lower. The Fed does not have too many cuts left in the bag.

The liquidity trap beckons.

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