A Very Cautious Fed

wall street journal

December 12, 2007 7:32 a.m.

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If many investors seemed caught off guard by the Federal Reserve's move to lower interest rates by just a quarter point, the Fed itself seemed to be acting out of caution bred by heightened uncertainty about where the economy's going.

The steep decline in stock prices yesterday came when the markets didn't get the half-percentage-point cut so many analysts had described as "baked in" or "priced in" or whatever the jargon du jour happened to be. When the Fed lowered its target for the federal-funds rate for overnight loans between banks to just 4.25%, the markets tanked. The Dow Jones Industrial Average closed down 294.26 points, or 2.1%, at 13432.77. Most Asian markets suffered similar declines today, and at midday all the major European stock indexes were trading lower as well. Bloomberg and others say this suggests a split of opinion between the Fed and the markets. But if there's a sense on Wall Street that, as Morgan Stanley economist David Greenlaw argues to The Wall Street Journal, "the Fed doesn't get it," Fed policy makers themselves might consider such ignorance the healthiest point of view.

Fed predilections toward lowering or raising the cost of borrowed money stem from how they judge the balance of risks between the threats to economic growth and the threats of rising inflation. Yesterday, members of the Federal Open Market Committee declined to express any guess on that balance. Instead, they settled on stating that "recent developments, including the deterioration in financial market conditions, have increased the uncertainty surrounding the outlook for economic growth and inflation." Stung by the need to reverse their relatively rosier statement at the last FOMC meeting on Oct. 31, FOMC members apparently want to wait and see what happens next. The strains on financial markets seen to be easing in October have now increased, while "incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending," the Fed acknowledged. And while the last rate cut was deemed pre-emptive insurance against "adverse" economic problems to come, yesterday's was described as the fuel for greater borrowing the economy needs now.

The Fed's last Beige Book compilation of regional Fed reports suggested labor markets remained relatively tight overall, meaning a nascent inflation threat remains. And as the Financial Times reports, the U.S. Agriculture Department warned of additional shortfalls in cereal stocks, which could feed food inflation, which, like the high global petroleum costs, can feed accelerated growth of overall consumer prices. But whatever the Fed said, inflation isn't the bigger worry; a lack of available credit for businesses to spend and build and hire is. As the Journal reports, the Fed is looking at a variety of other measures to further address the credit crunch, "including another cut in the discount rate [on loans it makes directly to banks], longer-term loans to money-market dealers, easier collateral rules for loans from the Fed, and other steps." Because whatever the U.S. economy brings between yesterday's Fed meeting and the next one in January, it doesn't look good.