On Monday, I opined on the Fed’s hesitation to cut rates when such a call should be a slam dunk. Why not step forward with the intermeeting cut?
Could the Fed possibly have given up hope on rate cuts, and instead intend to focus on other policy measures? Fed Chairman Ben Bernanke yesterday made clear that given the deterioration in the real economy, a rate cut was on the table:
Overall, the combination of the incoming data and recent financial developments suggests that the outlook for economic growth has worsened and that the downside risks to growth have increased. At the same time, the outlook for inflation has improved somewhat, though it remains uncertain. In light of these developments, the Federal Reserve will need to consider whether the current stance of policy remains appropriate.
Moreover, the minutes from the last FOMC meeting indicated that there was already some thought to a rate cut “way back” in September:
Some members emphasized that if intensifying financial strains led to a significant worsening of the growth outlook, a policy response could be required; however, such a response was not called for at this meeting.
Wall Street, however, was unimpressed by confirmation of an imminent rate cut. There appears to be no shock value in such news. Indeed, equity markets plunged even as expectations grew that a global coordinated rate cut is likely as early as Thursday, and if not then, this weekend.
The Fed can only disappoint, it appears. Or perhaps market participants simply feel that lacking a functioning credit channel, rate cuts are now simply a sideshow to the financial crisis.
I would not disagree. The Fed can provide infinite amounts of liquidity, but if it does not get into the hands of someone who will spend it, then it is just worthless paper.
One argument against a rate cut is that it risks upsetting a very nice little equilibrium the dollar has shifted into as global deleveraging in the financial sector looks to be forcing a rapid unwind of dollar based carry trades. The more stable dollar, and the subsequent downward pressure on commodity prices (with the exception of gold), eases the US inflation outlook, which in turn gives the Fed room to cut rates.
The pressure to ease, coupled with pressure to sustain the dollar, thus argues for a coordinated cut, as 50bp across the board would leave interest rate differentials unchanged. In theory, this would allow the dollar to hold its ground while delivering the easing that everyone expects and expects to be meaningless (although it provides grist for bond traders).
Of course, 50bp is all the Bank of Japan has to give, so it takes something of a leap of faith to see them go along with such a plan.
Current dollar supportive dynamics notwithstanding, the path of monetary policy is placing the dollar in an increasingly perilous position – if credit channels refuse to loosen, the Fed will be driven inexorably toward policies that attempt to place cash directly in the hands of those that will spend – such as yesterday's leap into the world of commercial paper. And as the Fed draws more and more risk onto its balance sheet (as well as the US government, via TARP), its credible commitment to price stability will be increasingly in doubt.
Will outright monetization soon be the only remaining option if the Fed is under pressure to restore spending power to the US economy? Is outright monetization really off the table at this point?
Consider that Bernanke is widely thought to be determined not to make the same mistakes made by the Fed of the 1930’s. Consequently, he has pulled out all the stops, cutting rates quickly and lending freely on a wide range of collateral. But the credit crunch continues unabated, as this is not simply a panic, but a massive deleveraging brought about by fundamental insolvency.
Recession is now unavoidable, and the length of the downturn grows longer with each day the credit markets are constricted. Short term interest rates are headed toward zero, suggesting a liquidity trap. What options are left?
Bernanke must have at the back of his mind the incident that many believe ended the Great Depression – the 1933 devaluation of the dollar as the US left the gold standard. Certainly outright monetization would bring such an end; and going back to the Great Depression has been a good way to look for Bernanke’s next move.
Maybe this is getting ahead of ourselves; maybe not. I think it is important to remember that as we head into next year with a profoundly weakened consumer, the calls to “do something” will be increasingly louder.
Actions to date have centered on fixing the financial system; the billions in debt soon to be issued for TARP are not likely to flow into the hands of ultimate demanders. And if credit channels remain broken even after these efforts, near-term options to support growth are limited. Monetization of deficit spending is one such option.
Bottom Line: The stage is set for a rate cut; only the timing is at issue. If a rate cut does not come via coordinated fashion by next Monday, it is safe to assume that the Fed intends to move rate policy back to its regularly scheduled meetings. The Fed’s apparent hesitation to cut in the midst of a significant equity sell-off (13% on the Dow in five days) and credit collapse is puzzling given their past behavior.