50 Basis Points

I don’t expect that the Fed will cut the federal funds rate target by 50 basis points at its next meeting, but I do think that would be a good idea. (This conversation started on William Polley’s blog, but it’s going to get too long for a comment.) I see every reason to prefer erring on the side of too much stimulus rather than too little:

1. With the release of the payroll employment figures for August, as well as the revisions for June and July, not to mention the widely expected prospect of additional downward revisions when the real data on births and deaths come in, we face the serious possibility that the US was already in a recession when August’s financial crisis hit. (That’s in addition to the possibility that we went into a recession in August, and the possibility that the effects of the financial crisis will tip us into recession over the coming months.) If it turns out that the recession began before the financial crisis, we will be experiencing a deepening recession over the coming months, and
   
   
2. that recession could get really ugly. Although I made optimistic noises last year about the tractability of any possible recession, I am becoming increasingly worried about the possibility of a policy-resistant recession. Consider that
   
   
   • the international savings glut is still with us, and, if anything, it’s about time for the US to join the glut rather than playing the hero, as
     
     
     • American households have had a negative personal savings rate for two years, and this is unlikely to continue given the now more limited prospects for capital gains on assets and more restricted access to low-priced credit.
       
       
     • America’s children are about to graduate from college, which puts Mr. and Mrs. America at the point where it’s time to stop worrying about the kids and start panicking about inadequate retirement savings.
       
       
     • tax cuts are going to expire soon, and the Democratic congress is unlikely to extend them.
     
     
   • If the international savings glut should disappear, then we face the prospect of a potentially stagflationary fall in the dollar, which would inhibit the use of policy to end the recession.
     
     
   • A conventional monetary stimulus may in any case prove ineffective, given the “once bitten” status of the housing market and the unresponsiveness of capital spending. I don’t think Ben Bernanke wants to be in the position of having to use his helicopter.
   
   
3. By the standards of the last 50 years, the inflation rate is damn low. The 12-month growth rate of the core consumption deflator is within the target range. Inflation expectations are well-contained by almost any reasonable measure – with median expected 10-year CPI inflation (according to the Philadelphia Fed’s Survey of Professional Forecasters) recently falling below the 2.5 percent level where it has spent almost all of the past 10 years. The weight of risks is overwhelmingly on the side of too little growth rather than too much inflation.
   
   
4. From an economic point of view, monetary policy will still be tight, even after a 50 basis point cut. If you take the rule of thumb that the neutral real overnight interest rate is 2%, and add that 2% to the core PCE inflation rate, you get 3.9%. OK, maybe you don’t buy that – so make it 4.2%, or even 4.5%. But 4.75%? No way is that a stimulus policy.
   
   
5. The longer-term prospects for the dollar are dismal, but at this moment, everyone wants dollars – probably because so many foreigners are trying (or being forced) to unwind levered positions in dollar-denominated assets. Instead of saying, “Let them eat euros!” why not give them the dollars now, and you can take them away later if necessary. If the stimulus turns out to be ”too much” from a business cycle point of view, so much the better from an “orderly foreign exchange markets” point of view. When the world has had its fill of dollars and the thought of the dismal US international investment position starts to cause indigestion, it will be just in time for the Fed to prevent a free fall by raising interest rates in the face of an overheating economy. I’m not advocating exchange-rate targeting, and under normal circumstances, I would say that the Fed should ignore the value of the dollar (except to the extent that it alters the picture for expected employment and inflation). But after so many years of huge and growing current account deficits, these are not normal circumstances; the Fed needs to worry about how potential exchange market instability might constrain its future actions.
   
   
6. History will forgive a recently appointed central banker for overreacting to a financial crisis. (It surely forgave the former Chairman when he overreacted to the stock market crash.) History will not deal so kindly with a central banker who allows the economy to fall into an intractable recession. When the Emperor smells smoke, even if the odor is rather faint at first, he had best put down his fiddle.
   
   
7. One of the mistakes of the last easing cycle was not to cut aggressively enough in the beginning. Ultimately (we can say with hindsight) the easing cycle went too far, but it definitely started too slowly. The Fed was also too slow to ease in 1990-91. The Fed has a lot of inflation-fighting credibility today, and should the economy seem to move in the direction of overheating, the Fed can take back any easing moves without having lost much ground. But you don’t get a second chance to prevent a recession.
   
   
8. All the reasons that I have given already are things the financial markets can figure out for themselves. If the Fed only cuts by 25 basis points this month, markets will have good reason to expect another cut in October. If the Fed cuts by 50 basis points, it can credibly avow a reasonable hope that no further cuts will be necessary.