The Fed's 125bp Two-Step

My blog entry about the surprise rate cut Tuesday was very much a gut reaction, put out very quickly as my gate was being called at Heathrow. But it's received a lot of attention in the blogosphere, and with 24 hours' hindsight (and a bit of embarrassment about an unnecessary "now" in the blog entry) I have no regrets. I do think that the move smells of panic and of trying to support the stock market, and I'm not remotely swayed by James Hamilton's attempt at rallying to the Fed's defense:

I doubt very much that anyone on the FOMC has much interest in protecting the investments of stock market participants. Instead, I suspect that the Fed is using equity prices just as I and many other economic analysts do, namely, as a useful aggregator of private and public information about near-term prospects for economic growth.

If the Fed was really just treating the stock market as a kind of economic prediction market, then there would have been no urgency to cut rates yesterday, rather than waiting until the regularly-scheduled meeting. After all, on a macroeconomic level it's hardly going to make a huge amount of difference whether you cut rates one week or the next.

To be fair to the Fed, however, there is one reason for cutting rates a week early which doesn't involve the stock market. Let's say that the Fed, looking at all its favorite indicators including the stock market, decided that the economy needed 125bp of rate cuts by the end of the month. It could either cut by 125bp at the regularly-scheduled meeting, or it could cut by 75bp yesterday, and then by another 50bp next week. It's definitely possible that the two-step approach would look less drastic and panicked than the one Monster Cut.

But for a longer and more coherent defense of my gut view against the more considered opinions of Hamilton, I point you to Steve Waldman, who resuscitates William Poole's November speech on the "Fed put". Poole, notably, was the sole dissenter on the FOMC yesterday, and he's also the Fed member who's most willing to admit that the put exists, although he doesn't consider it particularly harmful.

In any case, I think it's fair to say that if the Fed doesn't cut rates on January 30, Hamilton's defense goes up in smoke. But of course they will.