The Federal Reserve announced today it was lowering its target for the fed funds rate 75 basis points, from its previous value of 4.25% to a new value of 3.5%.
The Fed’s statement itself does not read like such a big deal:
The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets.
But actions speak louder than words, and this is a big action. This appears to be the first time in the 25 years for which we have a decent series for the Fed’s target that the Fed has implemented such a large cut in a single move. Another unusual aspect of the measure is that it came a week before the Fed’s regularly scheduled FOMC meeting.
The closest precedent for today’s action would be April 18, 2001, when the Fed announced a 50-basis-point cut 4 weeks in advance of its regularly scheduled meeting. The cause on that occasion was intermeeting evidence of deteriorating economic conditions. We now know in hindsight that the economy was already one month into recession at the time of that April 2001 decision.
The Fed’s action appeared to be prompted by turmoil in international equity markets. While Americans were on holiday Monday and still asleep Tuesday morning, London’s FTSE 100 index fell 5.5% and Japan’s Nikkei 225 lost 8.7%. Indian stocks fell so quickly that the Bombay Stock Exchange halted trading.
Felix Salmon doesn’t like the idea of the Fed responding to equity prices:
There’s one reason and one reason only that the Fed took this move, and it’s the plunge in global stock markets on Monday, along with indications that the US markets were set to follow suit.
Now the Fed is charged with keeping employment high and inflation low; it’s not charged with protecting the capital of investors in the stock market. So this action smells a bit like panic to me, and it might also have prevented the kind of stomach-lurching selling which could conceivably have marked a market bottom. I have to say I don’t like it.
I doubt very much that anyone on the FOMC has much interest in protecting the investments of stock market participants. Instead, I suspect that the Fed is using equity prices just as I and many other economic analysts do, namely, as a useful aggregator of private and public information about near-term prospects for economic growth. All the recent indicators have suggested a significant deterioration of real economic activity over the last two months. I take the global stock market sell-off as one more confirmation of that assessment, and new information about the global scope of the problems we face.
Mook, a commenter at Calculated Risk, offered this colorful analogy:
The Bernanke Fed is like a 19-year-old army trainee who’s never fired a shot in anger and is suddenly dropped behind enemy lines with an Uzi.
He’s shaking in panic but gripping his trusty gun tight, secure in his ability to destroy whatever foe he comes across.
The problem is, he fires off a half-clip in panic every time the wind rustles the trees.
Pretty soon he’s going to stumble right into an enemy squadron and pull the trigger, only to hear the fateful ‘click-click’ that indicates he’s out of ammo.And anyone who’s watched a war movie knows what will happen then.
I agree with Mook on this much– a 75-basis-point cut can not prevent a recession, if one is indeed already under way, any more than the 50-basis-point cut in April 2001 prevented that downturn. But, while many members of the public may believe in the Fed’s omnipotence, I doubt that members of the FOMC share that illusion. I expect that Bernanke instead simply intends to do what he can to mitigate the damage.
My bottom line? I believe the FOMC cast its vote today with those who declare that a recession has already begun.
Technorati Tags: macroeconomics,
economics,
Federal Reserve,
subprime,
interest rates,
fed funds rate,
fed funds futures,
Bernanke,
recession
JH, I am not too sure of this:
I do believe that the Fed has decided to mitigate, as much as their actions can, the loss of wealth. Monday’s market loss across the world was the handwriting on the wall. They just tried to lessen its impact here.
I think you’re dead on right about this. We are undoubtedly already in a recession, only we can’t call it that because the powers that be have defined a recession in a different way: It’s always looking backwards.
Too bad we can’t call a spade a spade.
Today’s move looked like Bernanke not only blinked, but he panicked. This move could have been smaller but earlier. These guys have all the data at their disposal and they don’t have the smarts to see what it’s telling them.
The Fed is like the weatherman. While most people just look out the window and see rain, the Fed looks out the window, sees nothing, goes outside without a jacket, and wonders why they get wet, only later to proclaim, “It rained yesterday.”
Fools.
Professor,
What is the recession probablity calculation that you used to present in this blog showing now? How can we relate that to what is actually happening now?
“The stock market predicted nine of the last five recessions.”
Paul Samuelson
TedK, my recession probability index is in the class of backward-looking indicators that billspaced criticized above. We will wait until the “advance” GDP 2007:Q4 estimate is released next week before issuing our “final” declaration on 2007:Q3. But I’m quite confident this will lead us to declare that the economy was not in recession in 2007:Q3.
I expect to give the official word on recession here long after everybody’s convinced it’s a reality, but before NBER makes its declaration. I also expect that, when we give the declaration here that the recession is over, we’re more likely to be ahead of the curve (at least as far as the mainstream media is concerned), and the declaration will be greeted with more surprise and skepticism.
In any case, my index, like the NBER “official” declarations, is designed to be quite certain of the facts before making the call. But of course it’s more fun for all of us to shoot from the hip– this time, those who’ve just fired may well turn out to be correct.
Mitigating damage is pretty much all the Fed can do with the current situation. With a significant disruptive event beginning in the stock market this month, which often coincides, but not always, with periods of recession, the Fed has little choice but to act as if a recession is an inevitable outcome to help manage expectations.
I agree with your assessment:
http://hallofrecord.blogspot.com/2008/01/rate-cuts-are-we-there-yet.html
The yield curve is still inverted all the way out to 10 years. They’ve still got a lot of cutting to do.
A lot of cutting from what? That clip’s already tapped and it’s clear that everyone knows we don’t have any silver bullets. Zoom out a bit and it’s not hard to see that these dramatic events are the effects of punctuated equilibrium. Lingering fat-and-happy inertia and some very poor and shortsighted legislation over the past 6 years have been banking on an artifically rosy future. Well, the future is here. Get out your scythes and start reaping.
“I doubt very much that anyone on the FOMC has much interest in protecting the investments of stock market participants.”
Right. A servant of the elites would not have much interest in protecting their interests?
“I doubt very much that anyone on the FOMC has much interest in protecting the investments of stock market participants.”
If you really believe that, why do you think doing this next week, rather than today, matter?
What was the critical need to do this today?
Can you comment on the historically low Non-Borrowed Reserves found at http://www.federalreserve.gov/releases/h3/Current/ ?
Apologies if this is way off point, but I’m struggling to understand the implications in the data, and it sure seems to be mixed up in today’s move somehow.
bumble said
Why today? To mitigate the market dump that was evidently on today’s horizon. It has mitigated it so far. But, the real question is what about tomorrow and tomorrow?
bumble, here are two possible answers to your question. (1) A financial panic will be extremely unpleasant for the people at the bottom of the U.S. economic ladder. A desire to prevent a financial panic in no sense whatever equates with a desire to protect investors. (2) The Fed wants to cut an additional 25-50 basis points next week, and moved today because 100-125 was too much in a single step.
And now let me ask you a question. Suppose you care only about the American working class and no one else. The one policy tool you have is the level of the fed funds target. What value do you choose, and when do you choose to change it?
To me, the value of equities is highly relevant information for purposes of predicting what the unemployment rate is going to be six months from today. That is a statistical statement, not something emerging from the ideology of class struggle.
I thought that stock markets had predicted the last 12 out of 6 US recessions.
That’s not necessarily a bad score compared to other forecasting techniques.
Perhaps there is some recent evidence on stock market forecasting abilities I should be looking at?
The last time the 10 year was under 3.5% was ’03. The fed funds rate was 1% at the time. That’s where the Fed needs to go. Fast.
And I look forward to refinancing my McMansion.
two of the prior inter-meeting cuts occured during option expiration weeks and this one occured the trading day after.
i’m going to guess that the fed was sitting in wait on friday to see if a speculative attack occured on the market and since it didn’t they waited and were awakened monday to a plunge adn then acted.
this is why i don’t like the 19 yr old with an uzi analogy. these cuts have been timed to stop snowballing so far. uncle ben might be new but the rest of the members are doing a good job of keeping their new lieutenant at ease and abreast of financial landmines while behind the enemy lines of “easy allen”. they’re gonna hunt him down and give him a nice double tap with one to grow on.
To me, the value of equities is highly relevant information for purposes of predicting what the unemployment rate is going to be six months from today.
That seems too far-fetched. With the carry trade and cheap credit, the value of equities have simply become an indicator of speculative excesses.
This is similar to your expectation of obtaining inflation data from TIPS/bond yields. It doesn’t, and investors have got it wrong for quite some time, and lost money
See http://www.clevelandfed.org/research/inflation/World-Inflation/index.cfm#chart
for US
vs
http://clevelandfed.org/research/Inflation/TIPS/index.cfm?state1=1&state2=2&state3=&state4=&startDate=01/01/2001&endDate=01/22/2008&freq=monthly
I don’t think it’s just a coincidence that we reached the panic level immediately following the Fitch downgrade of Ambac. That move pretty much put the first nail in the first coffin of the financial guarantor racket, and the potential tidal wave of cascading downgrades and wholesale dumping is concerning to a central banker.
You also have the huge counterparty risk issue highlighted in the Merrill Lynch 4Q where they took a $3.1 billion reserve against now worthless credit enhancement products purchased from ACA Capital Holdings.
The Fed probably doesn’t care much about the stock market, but they are tasked with forestalling the collapse of the financial system and will do a lot to avoid a nuclear meltdown if they can help it.
The other straw that may have helped break the camel’s back was the writing off of $8 billion by the Bank of China due to bad US subprime yuck that they hold. The spreading of this mess to China is clearly a big deal, and something not previously observed. After all, the only stock market in the world to rise yesterday was Sri Lanka’s.
I would also be a bit wary about this 19-year old with an Uzi stuff. Gentle Ben was on the Board of Governors for several years prior to his brief internship as CEA Chair for Bush to vet him. And the Vice Chairman of the Board is the redoubtable Donald Kohn, up from longtime service on the staff, and reputedly the right-hand man, if not the actual brains, of Alan Greenspan.
E. Poole:
I recommend an article by Gerald P. Dwyer Jr. and Cesare Robotti at the Atlanta Fed “The News in Financial Asset Returns” (2004). You can get it from the Atl Fed site. They find evidence that financial data can help predict movement in the economy.
Professor,
Thanks for the explanation about the recession probability index.
I have another question: If the Fed is taking the equity market prices as “a useful aggregator of private and public information about near-term prospects for economic growth,” why doesn’t the Fed act similarly to increase interest rate in a timely way when stock/real estate markets overheat?
I don’t think the Fed took similar note of the overheating real estate markets in 2002 and 2004 even though the UK’s Mervyn King started worrying about the housing bubble there early on.
I was one of those who took the views of Stephen Roach on asset bubbles (income-based savings vs asset bubble) seriously as far back as in 2003, and thought that the current scenario would play out sometime in 2004. That didn’t happen. By then it had become clear that there was also a credit bubble. I am worried that this action by the Fed may lead to continued expectations of rate cuts and another bubble–i.e., it is simply postponing the necessary correction.
Whenever I think of the Federal Reserve coming to policy decisions, I imagine twelve highly educated individuals fiercely debating statistics and extrapolations of current data, eventually coming to a decision based on practicality, precedent, and sound reasoning.
But today seemed like a “equities Selling? Cut rates!” day. Why does the Federal Reserve have a responsibility to prop up the market before a panic, and then pretend like they were doing it for other reasons all along?
Having a deus ex machina angel fly in to save the day does little to instill confidence in the system itself. Or, thats my feeling on the subject.
There’s a bunch of mysterious inside sources who’ve been saying that the Bernanke Fed really wants to separate the two policy functions of the Federal Reserve – (a) adjusting monetary policy to help manage the economy and (b) throwing out an occasional BURST of liquidity as needed to keep the system from seizing up when a credit crunch bites.
So. Over the course of 2007, the Bernanke Fed only made changes to the FF rate (for managing the economic outlook) at regularly scheduled FOMC meetings, and they tried several different ways of using the discount rate (TAF auctions, etc) to provide the liquidity to offset the credit crunch.
For a variety of reasons, the new Bernanke method left the FED wildly behind the curve in terms of providing liquidity to the system and that’s part of what the panic over the weekend was about. Note that in the FOMC statement today that “Crazy Bill” Poole STILL WANTED TO WAIT UNTIL NEXT WEEK to change the FF rate.
Anyway, I for one am glad the Bernanke method has for now gone by the wayside and we got a nice FF-related burst of liquidity OFF-SCHEDULE but on a much needed basis.
Tedk, I can’t defend the Fed on that one. We all agree now that the Fed was overstimulative 2003-2004, and real estate prices would have been one valid indicator of that.
Kevin Adolph, I have no inside information, but my guess is that the FOMC members already had a clear idea they were going to make some big cuts even before equity markets opened in other countries on Monday.
It is not about preventing recession, as much as making sure the recession is short and shallow.
The TAF was brilliant. The rate reductions were well-timed. Bernanke is the best.
It isn’t within the power or responsibility of the Federal Reserve to hold unemployment or GDP to “tolerable” levels. In fact, to assume that the Federal Reserve can solve our unemployment problems is to assume the problem is so simple that its solution requires only that the Manager of the Open Market Account buy a sufficient quantity of U.S. obligations for the accounts of the 12 Federal Reserve banks. This is utter naivete.
Other than housing most of the “real” USA economy doesn’t seem too bad, and most of the rest of the world remains robust.
What is clearly causing concern in world equity markets is distress in the financial system sparked by sub prime, cdo and cds valuation concerns. Specifically the trigger for the latest bout of selling was the downgrade of the monoline insurers and recent bank, particularly Citi results. The market worries that debt on the books of the financial sector is still being carried at too high a price.
What interests me is how (di)stress in the financial system will be transmitted to the physical economy.
Banks as a system dont loan out anything.
They create money when they make loans
Money creation is not self-regulating
You cant take money out of the banking system (only the FED can)
Savings transferred through the intermediaries never leaves the CB system. The intermediaries are the customers of the CBs.
Savings held within the commercial banking system are lost to investment or to any other type of expenditure.
From the standpoint of the economy the banks shouldnt pay for something they already have.
Payments on savings raise all interest rates, induce disintermediation among the financial intermediaries, shrink real-gdp, & vastly increase CB profits.
The solution to our non-bank problem is to get the money creating depository institutions out of the savings business.
correction: should have been “lower CB profits”
“my guess is that the FOMC members already had a clear idea they were going to make some big cuts even before equity markets opened in other countries on Monday.”
Surely the world markets collapsing on Monday had something to do with the timing. It wasn’t just a coincidence right?
Kevin, yes for sure the timing of the announcement was in response to market events. But I’m saying that the notion of a 75-basis-point cut did not just pop into their heads on Monday.
The “Fed put” in action
Felix Salmon writes, regarding this morning’s heroic 75 bp rate cut:
January 22, 2008
Shock and awe in the markets today as the Fed cut 75bp to 3.5% and the Bank of Canada cut 25bp to 4.0%. James Hamilton at Econbrowser labels the Fed move an attempt to mitigate damage:
a 75-basis-point cut can not prevent a recession, if one is indeed…
JDH,
I believe you are glossing over the significant change in Fed policy that occurred today.
The Bernanke Chairmanship was supposed to depart from his predecessor’s in an important way: less reaction to implicit market forecasts, more reliance on econometric models with theoretical grounding and empirical validity.
Where are those models today? What is the Chairman using to navigate policy without them? Mishkin and others have been busy trying to erect a separate analytical construct: drastic measures are required when they are required. Does this really pass muster?
The irony, of course, is that Bernanke will have a big problem should the rate cuts succeed: the market will demand the same gradual, transparent, telegraphed raising of rates that Greenspan delivered. And, of course, Bernanke will have to oblige. If inflation accelerates, he will be powerless to act, lest he find himself again in the position of having to reassure the markets that rate hikes will not derail a recovery.
“I doubt very much that anyone on the FOMC has much interest in protecting the investments of stock market participants. Instead, I suspect that the Fed is using equity prices just as I and many other economic analysts do, namely, as a useful aggregator of private and public information about near-term prospects for economic growth.”
Good but ultimately unpersuasive defence. If that is the case, one week would make a big difference, is it?
I’m trying to reconstruct a statistical test that shows that the markets are an indicator of short-term growth prospects. My naive regression of GDP growth against lagged S&P returns doesn’t show anything. What am I missing?
Many naive comments. Read WSJ-Croushroe. Bernanke is not responding to the avaricious. He is the guru of credit flows and the need for small business to grow and expand.
Couldn’t say, Josh. I assigned that exercise as an example for students a couple years back, and the relation appeared quite strong. Here are links to regression output, regression code, and data ([1], [2], [3]).
JDH — Thanks. I quickly ran my test this morning against data from 1980 to today. And I was looking for p
Duh. Helps if I can read my own output. Even with my data it is significant. My bad 🙂
$GDP
Call:
lm(formula = y ~ -1 + ., data = datamat)
Residuals:
Min 1Q Median 3Q Max
-0.0165980 -0.0039543 -0.0004569 0.0030966 0.0276737
Coefficients:
Estimate Std. Error t value Pr(>|t|)
GDP.l1 0.368162 0.086886 4.237 4.84e-05 ***
SPX.l1 0.017983 0.008432 2.133 0.0353 *
const 0.009113 0.001439 6.333 5.93e-09 ***
—
Signif. codes: 0 *** 0.001 ** 0.01 * 0.05 . 0.1 1
Residual standard error: 0.006767 on 106 degrees of freedom
Multiple R-Squared: 0.8433, Adjusted R-squared: 0.8389
F-statistic: 190.2 on 3 and 106 DF, p-value:
Your using the wrong data.
Carnival of the Capitalists for January 29, 2008
This week’s guest host of the Carnival of The Capitalists is cehwiedel from One Man Band: DIY Online Business for One. She is a freelance commercial writer with 35 years experience writing everything from technical manuals to news releases to website…
I got the heads-up from a couple of posters back at CR that I was quoted here. Quite flattering, I must say!
In case there’re any misconceptions about the analogy: I am not convinced that we’re already in a recession (though I certainly wouldn’t be surprised), but am convinced that the 75bp cut isn’t going to make any difference one way or another.
The bigger issue, to me, falls under the rubric of ‘Perception equals reality’. By 6am ET CNBC was noting that traders were screaming for an immediate cut from the Fed, and by 8am they had it. It doesn’t matter whether the Fed panicked or whether they’d had this move planned for weeks … what matters is that it looked like panic.
Considering Dr. Bernanke is in charge of an institution whose primary mandate is exercising perceived, rather than real, control over short-term interest rates, one would think they’d at least consider the power of perception. And considering that many of the problems we’re experiencing now stem directly from Alan Greenspan’s desire to be perceived as Wall Street’s best friend, one would think that Bernanke would also take pains to prevent being painted with the same broad brush.
So, no mention of that little tidbit from France informing the Fed’s impromtu rate cut? It sounds like Dr. Bernanke got gamed.