Fed Cuts US Interest Rates Another 50 BP

It’s hard to believe that just a week and a half ago, American interest rates were 1.25% higher. In that time, the Federal Reserve has cut rates twice. First, the Fed slashed rates on January 22 by 0.75% in a surprise move to shore up sinking stock markets around the world. Then on Wednesday, it cut them again by 50 basis points (that’s a half a percent) at its regularly scheduled meeting. The Fed seems to be more worried about stagnation than inflation and rightly so.

This journal remains unconvinced that there will be a recession in the US as classically defined, two consecutive quarters of negative economic growth. The fourth quarter 2007 GDP numbers, though, showed anemic (nay, European) levels of growth at 0.6%. The economy may well shrink in the current quarter, but a return to positive figures remains likely. Nevertheless, 2008 is going to be a year of minimal growth.

The trouble is that the American economy is not designed for low levels of growth. Too many assumptions are built into economic activity that are predicated on 3%-ish growth. Thus, an economy that isn’t growing at that rate feels like it’s in recession. All the same, a true recession may well occur. In any case, the Fed may well be12:30 PM 1/31/2008 facing stagflation like in the late 1970s.

Fiscal (tax-cuts, increased spending) and monetary (lowering interest rates) tools don’t work on stagflation. What fixes a stagnant economy sparks inflation, and what reduces inflation heightens the sluggishness of economic activity. As the Japanese learned in the 1990s, deflation is much harder to cope with than anything else. For a decade, they spent and spent and spent, and nothing happened. Best to avoid that situation. Inflation has been beaten before in much less time than that.

So, the Fed needs to acknowledge that the inflation caused by oil price increases is akin to a tax not to wage expansion. Therefore, the best policy is to avoid economic contraction, accept the inflation that ensues as the price of avoiding deflation, and when the global economy has adjusted to higher oil prices (that’s what the market mechanism does over the long haul), then inflation can be tackled. Lower rates are the right medicine for now.

© Copyright 2008 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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