Monday, August 20, 2007

A September Cut would Make Sense

I’m not saying the Fed necessarily will ease in September, or even that it necessarily should*, but if it doesn’t (barring a dramatic improvement in credit conditions between now and then) I will be somewhat puzzled.

The Fed’s mandate is to pursue price stability and maximum employment. It pursues these objectives by influencing macroeconomic conditions in the real economy, but it influences those conditions using only financial instruments. In particular, it tries to hold the federal funds rate at a level that will produce the best macroeconomic results.

However, the federal funds rate has no direct influence on the real economy. It has indirect influence through a number of channels, and it also acts as an indicator of other indirect influences that Fed policy has on the real economy. I won’t attempt an exhaustive list of these channels and influences, but among them are: corporate bond yields, which help determine capital spending choices by corporations; commercial loan rates, which also help determine capital spending by businesses; commercial paper rates, which help determine the cost of holding inventories; consumer interest rates, which help determine spending by consumers; mortgage interest rates, which help determine housing demand and consumers’ ability to draw on home equity; housing values, which help determine consumer spending through a so-called wealth effect; and the availability of credit, which influences all these things by determining consumers’ and businesses’ ability to take advantage of whatever rates are offered.

One thing all the mechanisms I listed, and undoubtedly some others that I didn’t list, have in common is that they have all deteriorated recently even as the federal funds rate target has remained constant. As far as financial influences on the real economy are concerned, the Fed is effectively (if unintentionally) following a tighter policy today than it was a few months ago. So if the Fed believed a month ago that a 5.25% federal funds rate would produce the optimal set of consequences for the real economy, it would not make much sense to believe today that 5.25% will still produce optimal consequences, unless, of course, the Fed thought that the condition of the real economy had strengthened.

But from the recent inter-meeting policy statement, it is readily apparent that the Fed does not believe the condition of the real economy has strengthened. If anything, it has gotten worse. Therefore, it seems to me, if the Fed governors choose to leave the federal funds rate target at 5.25% in the September meeting (again, barring dramatic improvements between now and then), they are either making a mistake or acknowledging that they made a mistake earlier by not having raised the rate higher in the first place.

* Just for the record, I do think that the Fed should ease, but that’s not the topic of this post.

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