I don't envy the fed. On the one hand, banks are being hugely hit by the fallout from the subprime crisis. Credit is tightening, become harder to come by, even for reasonably creditworthy borrowers. Housing is absolutely tanking. It appears that the rest of the economy is being hit hard. Oil prices are a giant drag on consumer spending. These things appear to argue for a rapid reduction in rates.
On the other hand, there are medium & long term inflationary pressures building. Gold and other commodity prices are telling us that the markets expect inflation to rise.
Worse, the dollar has dropped rapidly, and signs are that it will continue to decline in value against other major currencies. China and the oil producers are making noise about shifting their foreign reserves partially away from dollars and into other currencies. This means that DEMAND for dollars will decline. Now the price of dollars (its exchange rate is nothing more than a price) depends on the supply and demand for dollars (just like the price of anything else which is bought and sold freely). If demand from China/Saudi Arabia and others falls, and all else stays the same, the exchange rate will decline-- the dollar will drop in value. This is problematic, particularly if it happens quickly. On the upside, a devalued dollar, which of course has damaging effects, but it also should, over time, reduce imports, by making them more costly, and increase exports, by making them cheaper. If imports become more costly, perhaps Americans will CONSUME slightly less, and SAVE slightly more. This would be a very good thing. It WILL happen if the dollar drops far and stays down for a while.
Reducing interest rates puts pressure on the dollar, by making US investments less attractive to foreignors. So if the fed cuts rates, it could easily make a dollar bloodbath worse. And increase inflation expectations. Which is a problem. But now isn't the time to worry about it. To worry about the DOLLAR, yes. To worry about inflation, no. That simply will have to wait, even if it causes more pain to deal w/ it later. As for the dollar-- well, we're going to have to coordinate monetary policy-- Europe can stand lower rates, Japan's are so low still that it barely matters, UK can lower rates. The whole world will have to ease with the fed to avoid a total run on the dollar, but the fed simply MUST, as Summers put it, "Get ahead of the curve." Even at the risk of communicating PANIC to the markets, as Crook alluded to. Panic lasts a short time, but the effects of the interest rate cuts take time to be felt. You have to do it sooner rather than later if you fear possible disaster.
The day before the fed began this cycle of interest rate cuts, on September 18, 2007, I said to a trader I met briefly on the subway that I thought the fed should cut rates 3/4 of a point, and say, "we think we're done." He first looked at me like I was from Mars, but came to agree with me.
I have the same idea now. If the fed cuts by 50 or 75 basis points, it communicates panic. That's VERY bad. I would still do it. And accompany it with an announcement that we are now comfortably ahead of the curve, and the next move is likely up (a year or so from now). Say all that in fedspeak. It'll hurt the dollar, and it WILL build inflationary expectations. AND it will take pressure off of Congress to deal with spending. All this is bad. But I'd do it anyway. A bad recession is worse, both in lost output (which is perishable, and is never recovered) and in risks to the overall financial system (hitting weakening banks with a general business downturn is NOT what I'd really prefer."
Fed Chairman Me has spoken.
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