Fed Cuts Interest Rates 0.50%

For the first time in 4 years, the US Federal Reserve unanimously has cut the discount rate by 50 basis points to 4.75 % from 5.25%. Following a surprise cut a couple of weeks ago in the Fed funds rate, this reduction signals that the Fed is taking seriously the credit crunch that has spread from the US subprime mortgage market to other parts of the economy and other parts of the world. It is a case of getting the result right for the wrong reasons, but the world is better off for it anyway.

The Fed said in a statement, “Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.” That an obscure way of saying “the subprime market has caused credit to dry up and by making money cheaper to borrow, we’re trying to correct it.”

Inflation-obsessed pundits will worry that this reduction in interest rates will spur price increases. The fact is that oil traded at almost $82 a barrel for West Texas Intermediate just before the Fed’s announcement. That means prices were going to rise anyway. The Fed has never distinguished between the inflationary effects of wage increases that outstrip productivity and stagflationary pressures brought on by sudden increases in basic commodities, especially oil. A central bank can effectively fight the former with interest rate increases, but not the latter. The latter has the same effect as a tax, and raising interest rates when stagflation threatens only makes things worse.

The market was divided over the size of the cut before it occurred, and the market remained so afterwards. Some favored a 25 basis point reduction on the grounds that the Fed should move carefully. Others thought 50 basis points achieved much more immediately and left open the question of whether there would be further cuts. Such doubt is often useful in keeping markets from making one-way bets that ultimately undermine policy.

At 4.75%, the Fed still maintains a ridiculously high rate, especially with oil rising as it is. This journal believes that current conditions warrant a rate of around 3.0-3.5%, with room for further cuts if oil goes much above $90. Growth expectations for 2007’s second half are being scaled back significantly. As Lyle Gramley, a former Fed governor and now an analyst at Stanford Financial Group in Washington, told MSNBC.com, “You get as big a decline in housing as we are looking at and that is serious business. I think we will escape a recession, but just by the skin of our teeth.” However, having let interest rates get too high, the Fed’s credibility would be shot if it put things where they should be all at once. Pity.

© Copyright 2007 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Fedora Linux.

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