Eyes back on Fed for emergency rate
cut By Peter Morici
United States stock markets were lifted on
Tuesday on speculation that Federal Reserve
chairman Ben Bernanke will call an emergency
meeting of the Fed to further cut interest rates,
contrary to warnings by policy makers in the past
two weeks. The speculation was fueled by the Fed's
first set of quarterly economic forecasts, a
product of the new regime recently instituted by
Bernanke.
The degree of "uncertainty''
about the growth outlook is greater than that for
inflation, Fed officials said on Tuesday. While they
expressed confidence price
increases will ease, they viewed markets as "still
fragile and were concerned that an adverse shock''
would worsen economic risks.
This is a
remarkable turnaround for Bernanke.
On
October 31, the Fed cut the Federal Funds rate a
quarter point to 4.50% but essentially said that
it would not likely cut rates further. The Federal
Open Market Committee (FOMC) stated: "The
committee judges that, after this action, the
upside risks to inflation roughly balance the
downside risks to growth."
Since that
time, virtually all the economic news has been
bad. Wall Street firms are taking mega-write downs
on subprime debt (and Freddie Mac, the
government-chartered mortgage funding giant,
announced a $2 billion quarterly loss on Tuesday),
the stock market has tanked, retail and housing
sales are in the sink, commercial real estate
values are falling, and industrial production is
contracting.
It seems the Fed is under
pressure every few weeks to change course on
policy. After telling us the subprime crisis was
under control, both Bernanke and Treasury
Secretary Henry Paulson gave speeches on October
15 and 16, explaining why exceptional action would
now be required to rework adjustable rate
mortgages, re-establish mortgage markets, and
ensure general liquidity for the conduct of
business.
Which is it Ben: Are we in
trouble or aren’t we?
We are!
The
US economy is delicately walking along a precipice
between much slower growth and a tough recession.
If the housing "adjustment" turns into a rout, it
will be too late for the Fed to cut interest rates
enough to save the economy from a bad episode of
stagflation - rising unemployment caused by
evaporating household wealth and oil driven
inflation.
Yet, the Fed seems at sixes and
sevens on all this for five reasons.
First, the Fed has failed to grasp how the
damage in the subprime market to the balance
sheets of Citigroup, Merrill Lynch and others have
damaged fundamental confidence in Washington’s
economic management and undermined the resilience
of the US economy.
We have been suffering
a crisis of confidence for many weeks, and the Fed
doesn’t get it. If it did, the Fed would not have
precluded further action in its October 31
statement.
Second, unlike the European
Central Bank, Fed policymaking primarily focuses
on short-term interest rates and not money supply
management. In large measure, the US dollar’s
international status as the reserve currency -
other central banks use dollar holdings to back up
their currencies - makes both the supply of US
money and its impact on inflation unstable and
difficult to manage.
The practical problem
is that money is liquidity, and important segments
of the US economy are suffering from a liquidity
crisis.
Third, the Treasury and Fed have
failed to come to terms with the impact of China
on US monetary policy. China’s policy of
undervaluing the yuan and buying massive amounts
of dollars and securities, to keep down the prices
of the yuan and its exports on US store shelves,
has significantly unhinged US short-term interest
rates from US mortgage and other long-term rates.
Fifth, the Treasury and Fed have failed to
come to terms with the corrosive consequences on
bond, mortgage and wider credit markets of
self-dealing at Standard and Poor’s and other bond
rating agencies. No one is going to buy many
private US securities as long as rating agencies
are paid by Wall Street bankers who appear able to
manipulate the process.
In the near term,
the Fed needs to help avert complete meltdown in
the housing sector by bringing down long rates. It
should buy Treasuries on the long end of the yield
curve, as well as ensure adequate and affordable
liquidity in the short-term, commercial credit
market.
Immediately, the Treasury and Fed
should come out for sweeping changes in practices,
management and governance at Standard and Poor’s
and other bond rating agencies.
Given the
special status that bond rating agencies enjoy in
certifying investments for pension funds and other
public purposes, these changes should be more
sweeping than those under way at Merrill Lynch and
Citigroup. To emphasize the point, the senior
management at the rating agencies should not be
permitted to leave as cynically enriched as did
Stan O’Neal at Merrill and Chuck Prince at
Citigroup.
Peter Morici is a
professor at the University of Maryland School of
Business and former chief economist at the US
International Trade
Commission.
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