The Case For 2-1/4

The Federal Open Market Committee's next meeting is scheduled for April 29/30, which the May fed funds futures contract currently anticipates will result in another 25-basis-point reduction in the target fed funds rate down to 2.0%. Here's why I hope the Fed doesn't do that.

No matter how dire your outlook for the real economy may be, the first question that must be asked is, How much benefit could another 1/4-point cut provide? For home purchases, for example, the expected change in house prices and income over the next 12 months is likely to be a more important factor than the interest rate in the current environment. And even if the interest rate were the most important variable, it's not clear how much a 1/4-point reduction in the fed funds rate would actually matter for the cost of borrowing. For example, over the last six months, the Fed has cut the target by 250 basis points, while the cost of a 30-year jumbo mortgage rose 60 basis points. That's if you can still get the jumbo loan, which you may well not.

By contrast, there is a compelling case that by rapidly bringing the yield on short-term Treasury bills well below the prevailing inflation rate, the Fed has played a role in the significant depreciation of the dollar and increase in the dollar price of virtually every storable commodity that we've seen since the beginning of January. A USA Today/Gallup survey this week found that 80% of Americans are worried about rising gasoline prices and 73% about rising food prices, with about half of respondents claiming that these price increases had created hardships for them. Would lurching further down that road really stimulate consumer spending?

Markets are assuming that Bernanke will go to 2.0, and that expectation is built into the current price of storable commodities and the dollar. If the Fed instead surprises the market with a little restraint next week, I predict that we'd see immediate adjustments in those prices.

In part those effects would result from changing the fundamentals, surprising speculators with a higher real interest rate and firmer inflation-fighting commitment from the Fed than the market is currently assuming. But it's possible in my mind that there also is a psychological component to the current commodity speculation as well, in which case the Fed has a rare opportunity right now to get some extra benefits on the inflation front by breaking that psychology. However, if the Fed waits and lets the present perceptions become more entrenched, that same psychology could turn out to be a factor that later proves to work against the Fed and make anything it tries to do more difficult.

The Fed's credibility as an institution that will not tolerate a resurgence of inflation is absolutely critical for its ability to achieve its dual mandate. If the Fed loses that credibility, monetary expansion brings inflation but little output improvement, and monetary contraction brings a recession but little relief on inflation. When consumers report in the latest Michigan/Reuters survey that they expect 4.8% inflation over the next year, the Fed has a real problem in that department. If the Fed waits to pause until the June 24/25 meeting, it may find itself swimming against that credibility current for many years to come. I believe that the Fed has a unique opportunity to signal its true commitment at next week's meeting that may not come again any time soon.

Furthermore, if I am reading this correctly, we will not have to wait around to ponder what the outcome means. If the Fed surprises the market with a pause, we should have unambiguous confirmation or refutation of the hypothesis that the Fed has been contributing to the commodity price run-up within 48 hours of the FOMC's announcement. That knowledge in itself would also be extremely valuable-- valuable to the Fed in calculating how to chart its course from here, and valuable in terms of making clear to the public why sometimes higher interest rates are the better choice for public policy.

Chart source: Bankrate.com

Comments

[deaverb]

There is a practical aspect missing from all this. My wife's home loan went down $650 per month on the last ARM reset in March; her corporate loan has continually dropped over the last 6 months. All of this has helped family and business cash flow, and resulted in "other" purchases--not just interest payments. How can that not be a big deal over the whole economy?

[karchad]

I agree with his statement that the Fed should not lower. But as DeaverB says, it would provide short-term help to people. I'm just concerned about the inflationary aspect of such continued moves. I believe the media, for political purposes, is over-promoting the "disaster economy" scenario. I think we're in a slow-down, the Fed has lowered all it needs to, and should take a pause to see what happens over the next, say, 3 months.

[TPoise]

I believe the Fed should also pause the cutting. However, I believe they will not and will cut a quarter point. My hypothesis is that if they pause now, and the worse case scenario is true, and have to cut later, that will send more shockwaves through the market since the market has already priced in a second half recovery.

Imagine if we're in late June and we still get another cut. The whole notion of a recovery will be thrown out the window and the Dow would drop by at least 1,000 points in that scenario. Thus, the Fed will give us a quarter-point as "insurance". But expect a heavy-dose of language geared towards inflationary pressures.

[Egg]

While I agree they should stop cutting (and raise), I don't think there's any chance that Bernanke will not cut 1/4 point next week.

It's very clear based on the past year that he's beholden to WallStreet's expectations and since they expect it, they shall have it. Regardless of long term consequences via inflation.

[Abraham]

I would like to believe that Bernanke cares about us. But its like believing in the toot fairy. Lets face the facts: The Fed via Greenspan and Bernanke are ONLY beholden to their masters, Wall street and Bankers (investment as well as commercial).

The only prudent solution barring a major change in government (not likely, since Democrats=Republicans) is to cash out of the market and US banks and out it in a mattress (or Credit Union) where the Wall street and Bankers can't touch it. We need a new national political party that is NOT beholden to the Bankers that are killing us. Walk away from ALL DEBT, or pay it off and save (its your
decision). The banks think NOTHING of devaluing your assets or stealing your money. They don't feel guilty neither should you.
Visit "RunOnTheBank.org to learn about how to prepare and be prepared for your own economic system. Historically, this has been based on barter. During the First Great Depression, workers with REAL skills were valued by others. I am polishing up my mechanic skills for direct barter as well as my accounying skills to help the common person survive the attack of the Federal Reserve, Bankers and Rentiers.

[flow5]

The Great-Depression 2008: "We need a new national political party that is NOT beholden to the Bankers that are killing us". That's an understatement.

The powers of the Fed are limited. It's mandate is principally limiting the proxy for the rate-of-change in inflation to 2-3% above the rate-of-change in real gdp. If they did this the FOMC wouldn't have to worry about the liquidity and solvency of the banks and financial intermediaries.

[garye]

Why can't we just control mortgage interest rates. Brokers are providing loans on homes from 6% to 8% percent. Base on credit scores and other attributes as well. What would be the effect if there were a ceiling on mortgage interest rates @ 6%or lower. Allowing those that are in default or close to default to refinance at a interest rate cap of 4% until the economy is restored. This appears better than giving back the keys! With all of the fed interest rate cuts, mortgages have only declined slightly!!!