Wednesday, September 17, 2008

A Wise Non-Move

With the financial markets in ... ehem, turmoil to put it mildly (Fed bails-out AIG!!), and indicators such as unemployment, payroll growth, and industrial production clearly pointing towards a recession, what should the Fed do?

Our basic economic model would say: lower interest rates, unless a) they are pretty low already and/or b) inflation is looking un-tame. An analyst from UBS argued that Tuesday was "Time to Act" and that
We see the Federal Reserve easing 50bp to take US rates to 1.5% at today's
meeting. It is a close call, but we believe that the weakness in financial
markets is sufficient to warrant such a move. A 25bp easing would be regarded as
So, what did the FOMC do? At 2:15 on Tuesday it announced, to the great disappointment of financial markets, that it was leaving its main policy interest rate (the Fed Funds rate) unchanged at 2%.

Then, are interest rates too low already? Maybe you'd think so, since, given an annualized Core inflation rate of 2.43% (0.2% for August 08), even J McCain can figure out that the real inter-bank interest rate is negative (-0.416, to be exact). And yet, the FOMC itsel said

Most members did not see the current stance of policy as particularly
accommodative, given that many households and businesses were facing
elevated borrowing costs and reduced credit availability due to the effects
of financial market strains as well as macroeconomic risks

One gets the impression that either the FOMC isn't terribly sure of whether they are giving too much liquidity to the markets, or too little; or it thinks that it's in just-about-neutral territory, or both.

Then, is inflation a problem? Perhaps not - the BLS reported a negative Headline inflation rate (-0.1%) for August, owing to the drastic decline in oil prices in the last couple of days. But this has to be qualified in two ways.
  1. Oil (and food) prices are very volatile, so it's probably better to make policy based on the Core inflation rate, which is at the top of the Fed's comfort zone (it's at 2.43%, annualized).
  2. Second, the recent decline in oil prices doesn't at all reverse the impact of the elevated oil prices of the last - oh, one, two, three -- years. This is evident when instead of annualizing August's Headline CPI we look for its year-on-year growth rate: above 5%.
Indeed, the FOMC said
Inflation has been high, spurred by the earlier increases in the prices of
energy and some other commodities. The Committee expects inflation to moderate
later this year and next year, but the inflation outlook remains highly

It doesn't look (to me) that the Fed had very much downward room to manuever, not anymore.

Although economic prediction is an imperfect science, had the FOMC lowered the FedFunds, long-term interest rates would have risen, (long-term bond holders take into account expected inflation when they decide what interest rate is right for them). If the Fed had continued to pander to the scare-mongers, it would have signalled little concern with inflation, leading to higher interest rates on mortgages and for the corporate sector.

"Monetary Policy", such as lowering a broad-based interest rate is an appropriate tool when the problem is enormous and broad-based. They've already used that tool for that problem - now they are waiting for the negative-real-fedfunds rate to do it's trick, in a few months.

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