How much ammo is left in that fed funds gun?
Interesting reaction yesterday at the Chicago Board of Trade to the Fed’s decision to reduce its target for the fed funds rate by 75 basis points to a new objective of 2.25%. On Monday, the fed funds futures contract had been anticipating an average funds rate of 1.95% for April, consistent for example with a 100 basis point cut yesterday and some weakness prior to another 25 bp cut at the April 29/30 FOMC meeting. However, after yesterday’s meeting, the implied April interest rate shot up 20 basis points to 2.15%. The Fed made a big cut, and the market was surprised that it wasn’t even bigger.
To put these numbers in perspective, prior to January of this year, the Fed had not made a cut as large as 75 basis points in a single move in the available 25-year history of the series. And yet now we’ve reached a point where we’re surprised when the cut is “only” 75 basis points.
Still, I am glad to see that the Fed recognizes the need for at least this much restraint. I say that not because I am still mechanically thinking about a tradeoff between promoting real GDP growth and containing inflation. I think we are past that now. I could easily imagine this weekend’s developments with Bear Stearns as only the initial carnage in what may prove to be a very bloody financial crisis. I accept the view that job 1 is to try to contain that damage.
But suppose you believe that oil over $100 a barrel is a destabilizing influence– and I do– and that the Fed’s recent decisions on the fed funds rate are the primary reason that oil is over $100– and I do– and that further reductions in the Tbill rate have limited capacity to stimulate demand– and I do. Suppose you also saw a risk that the inflation, financial uncertainty, and slide of the dollar could precipitate a run from the dollar, introducing an international currency crisis dimension to our current headaches.
Well, if you did, then even if you were very, very worried about our current financial problems– and I am– you would still want to draw the line somewhere, and acknowledge that there is some point beyond which lowering the fed funds rate further will do more harm than good. When we’ve got that rate to 2.25%, and people are telling surveyors they are expecting 4.5% inflation, we need to be open to the possibility that we’ve already reached such a point.
I think the Fed missed an opportunity here. A 25 or a 50 basis point cut would have sent commodity prices crashing. Even the mildly hawkish surprise of “only” a 75 basis point cut may have some effects in that direction. If the Fed did convince the commodity speculators that their path leads only to ruin– and I believe the Fed could easily have done just that– that would leave Bernanke with a lot more maneuvering room to cope with what comes next. If the commodity demon were under control, maybe we’d have the breathing room later to bring the fed funds rate all the way down to 1%. While the speculation remains rampant, however, I expect to get nothing but trouble for the effort.
The Fed is firing its gun into the air. We may soon really wish we had some more ammunition.