Serious commentators are not taking recent market turmoil seriously enough. Barry Eichengreen (“The Federal Reserve will not let markets dictate a rate cut”, Opinion, Unhedged, August 6) and Claire Jones (Opinion, FT.com, August 8) both make cogent arguments for why Federal Open Market Committee members prefer to sit on their hands until September.
Unfortunately, not all market adjustments are created equal, and the appropriate response from the monetary authorities depends on the underlying reasons for market moves, and on the effects.
There are significant risks that the long-delayed US economic slowdown in response to Fed over-tightening is now in catch-up mode, which would be very non-linear. Moreover, Middle East conflict looks set to take a dangerous and unpredictable turn.
The extraordinary gyrations in Japanese markets counsel caution about global withdrawal symptoms now that central banks’ doping of markets has ceased. Stock market movements will affect wealth, and — with a lag — consumer and investment spending. However, much more immediate and severe economic dislocation will result if credit and housing markets correct, as seems likely — central banks blew an “everything bubble”.
Given mushrooming risks to the real economy, there is a persuasive case for a 50 basis points cut inter-meeting as insurance. The central forecast may not look bad, but central banking is also about managing risks and those risks are heavily skewed to the downside. Remember that the fed funds rate has risen relative to core personal consumption expenditures inflation by about 300 bps. The Fed is many months behind the curve and Fed rate cuts in the near term would still deliver significantly positive real rates.
The fact that US public finances are disastrously poor at this stage of the cycle and that a fiscal response to a downturn would be slow given the electoral cycle means that the Fed cannot afford to indulge its “wait and see” preferences.
The acid test of whether a 50 bps cut now would be a mistake is to ask if it would need to be reversed. Given the dynamics of inflation and growth, the level of real rates, and what markets are pricing over coming months, the answer is a decisive “No!” The Fed needs to swallow its false pride and deliver what the risk outlook now demands.
Paul Mortimer-Lee
Research Fellow, National Institute of Economic and Social Research (UK), Purchase, NY, US
