Aggressive Activism

With the economy shrouded in gloom, The Fed has a new economic script.
Economist StaffJanuary 31, 2008

No one could accuse America’s policymakers of standing pat as the economy flirts with recession. Congress is close to passing a fiscal-stimulus package worth just over 1 percent of GDP (the House of Representatives passed its version at $146 billion this week). And the Federal Reserve is loosening the monetary reins at the fastest pace in decades.

On Wednesday January 30, America’s central bank cut its policy rate by half a percentage point to 3 percent, little more than a week after slashing that rate by three-quarters of a percentage point in an unscheduled meeting. Official short-term rates have now fallen by 2.25 percentage points since the credit turmoil stemming from American mortgages began in August. With underlying inflation running at well over 2 percent, real rates are now barely positive. In a matter of days, American monetary policy has gone from broadly neutral to clearly loose. Gone is the incremental approach to altering interest rates. Instead there is a new Bernanke boldness.

The central bankers justify this shift on two grounds. First, evidence is mounting that the economy has weakened dramatically, making looser monetary conditions appropriate even though underlying inflation remains high. Second, Fed officials believe that the turmoil in financial markets, particularly the tightening of credit conditions, raises the probability of a nasty downturn. By acting quickly and boldly, the central bankers want to minimize the risk of such a calamity.

There is little doubt that the economy has slowed sharply. According to initial estimates published on the same day as the rate cut, output grew at an annual rate of only 0.6 percent; in the last three months of 2007 (or less than 0.2 percent; in quarterly terms), suggesting that America’s economy was barely growing at the end of last year. Toss in a revision or two and it is conceivable that this might mark the start of a recession. News from the housing market grows ever gloomier. The pace of home sales is still falling; the inventories of unsold homes are rising and prices are plunging. According the S&P/Case-Shiller index based on 20 big American cities, average house prices fell by 8 percent; in the year to November. Prices fell in every city in the last month. Retail-sales figures suggest consumers are growing more cautious and December’s surprise jump in the jobless rate raised alarm about the labor market.

But not all indicators point to disaster. Orders for durable goods and a private payroll report were surprisingly good. That suggests the Fed’s boldness is driven more by policymakers’ second rationale, that of reducing the risk of a negative spiral from financial markets to the economy. Hence the decision to slash rates on January 22, in response to a global sell-off. Strikingly, the Fed statement on January 30 mentioned “stress” in financial markets before discussing the economy. In a dovish text, the central bankers left no doubt that they were most worried about the downside risks and would act in a “timely manner” to address them.

Judging by the price of Fed fund futures, investors expect the federal funds rate to be as low as 2.25 percent by the end of the year. That highlights the danger in Bernanke’s new strategy. In trying to prevent financial-market calamity, the Fed may find itself pushed by Wall Street to leave interest rates too low for too long.