Fed rate cuts and monetary policy

The unprecedented decision by the Federal Reserve to cut the Federal funds rate by 75 basis points, the largest cut in over 21 years, to 3.5% has been not fully unexpected. It is now expected that the FOMC will further cut the rates to 3% at its next meeting on 30th January 2008.

An interesting reaction to the rate cuts has come from Paul Krugman. He has argued that the rate cuts may be a "pre-emptive" action by Ben Bernanke to not just ease credit supply, but also aimed at "maintaining a sufficient inflation buffer", if further cuts take the rates to the Zero Lower Bound (ZLB) and a possible "liquidity trap", a la Japan in 1990s. To that extent, some amount of inflation is desirable under such low interest rate conditions, so as to both encourage spending and give enough room for flexibility in case of rates being forced down further.

In a 2004 paper, Mr Bernanke had argued that the policy success in lowering inflation and interest rates, have increased the possibility of the nominal policy interest rate being constrained by the ZLB. This would limit the Central Bank's monetary policy options in stimulating aggregate demand.

The rate cut can restrict the Central Bank's ability to manouevre with monetary policy in other ways too. Coupled with falling confidence in the economy, it is likely to weaken the dollar and thereby makes imports more expensive. This in turn will stoke inflationary pressures, thereby limiting the Central Bank's freedom to use monetary policy, a vital economic policy tool to combate recessions.

The steep cut is also a very firm message from the Fed that the US Government that it will do everything possible to contain the financial market turmoil. It is a more effective response than small and repeated rate cuts, in so far as it reassures investors and shapes rational expectations. But on the flip side, it also reveals a sign of desperation and makes investors and lenders more wary, thereby exacerbating the credit crunch. It can give the impression that the Fed has played its final card and has now limited leverage in assuaging the markets.

There is also a concern that the rate cuts would paper over the deep rooted macro-economic imbalances that affect the US economy. Despite the recent declines, real estate and stock prices remain at historic highs and will need to undergo further correction. Even by the most conservative estimates, share prices will have to fall by atleast 10% and real estate by 20-40%, so as to reach normal levels. Such palliatives increases the probability of artificially glossing over the solvency problems facing many Financial Institutions and delays the inevitable hard decisions that are necessary for squeezing out the irrational excesses. As history shows, the more such things get delayed, the harder the landing.

Update
Martin Feldstein feels that the rate cuts may little to ease the credit markets given the deep rooted decline in confidence and absence of any mechanism to assess counterparty risks. He writes, "The lack of confidence in asset prices also translates into a lack of confidence in the creditworthiness of other financial institutions, impeding the extension of credit to those institutions. And because financial institutions do not even have confidence in the value of their own capital and in the potential availability of liquidity, they are reluctant to make new lending commitments."

He writes, "The current situation has the elements of a Catch-22: The credit flows needed for economic expansion require confidence in the values of existing financial assets, but market participants may not have such confidence while the risk of recession hangs over us."