Wait and see

tauringhuang.

Sep 17th 2008 | WASHINGTON, DC
From Economist.com

The Fed reckons the financial crisis has not yet seriously undermined the economic outlook

AP
DEFYING market expectations for a cut, America’s Federal Reserve kept its short-term interest rate target steady at 2% on Tuesday September 16th. The statement accompanying the decision was, at first glance, hard nosed. Ben Bernanke and his fellow central bankers reckon that “The downside risks to growth and the upside risks to inflation are both of significant concern”, implying an equal propensity to raise rates as to lower them.

But a closer read suggests the risks have tilted in the direction of weaker growth and away from higher inflation, though not by enough to put a rate cut on the table yet. “Strains in financial markets have increased significantly and labour markets have weakened further”, it said. “Tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters.” These all reflect more concern than the statement that followed its meeting on August 5th. Gone was last month’s reference to elevated inflation expectations.

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Still, given the convulsions that have just swept the markets—the bankruptcy of Lehman Brothers’ holding company, the bail-out of AIG and Monday’s 4% plunge in stock prices—why not cut rates?

To be sure, doing so might have been hard for the Fed’s hawks to swallow. Only a month ago officials thought their next move would be to raise rates, not lower them. On the other hand, inflation risks have clearly receded. The price of oil, which topped $140 a barrel in July, fell below $93 on Tuesday.

Consumer prices actually declined by 0.1% in August compared with the month before, the Labour Department said on Tuesday. That brought the annual inflation rate down to 5.4% from 5.6%. It will almost certainly fall sharply in the coming year. Core prices, which exclude food and energy, rose by 0.2%, keeping the core inflation rate at 2.5%. The Fed had thought core inflation might creep higher this year as prior energy price increases were passed through to other products, so the tame core reading might have been a pleasant surprise. Finally, with the unemployment rate now up to 6.1%, disinflationary slack is rapidly accumulating in the economy.

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The likeliest explanation for the Fed’s decision to stand pat is that it is too soon to know whether the recent developments have affected growth. The Fed may reckon that a 2% funds rate should be sufficient to get the economy through its current slump. There are also other tools to contain the risk: the Fed expanded the size of one of its lending programmes and broadened the type of collateral it accepts in another, and the Treasury has the ability to purchase mortgage-backed securities.

The risks that surrounded a potential collapse of AIG, of course, pose another problem altogether since its life-threatening crisis crystallised quite suddenly, and it is larger and more complex than Lehman. And unlike Lehman, the Fed does not know the firm well (it’s regulated by the state of New York). Christine Cumming, first vice-president of the Federal Reserve Bank of New York, voted in the place of the president, Timothy Geithner, who stayed in New York to oversee the rescue of the big insurer.

A rate cut now might not even have been felt: the collapse of Lehman has triggered a mad scramble for cash by banks, driving the interbank-lending rate as high as 6% in recent days. The Fed has responded with massive injections of cash into the money market to get the rate down. In that environment, a rate cut would have signalling value but would not rapidly translate into actual borrowing costs.