125 Basis Points
I just want to point out that the Taylor rule is still calling for a federal funds rate of 3.5%, and there are 125 basis points left to get there, so by this measure, the FOMC’s job has barely begun. Since the last meeting, the (12-month market-based core PCE) inflation rate has fallen (from 1.7% to 1.6%, rounded) and the unemployment rate has risen (from 4.6% to 4.7%, rounded, but mostly due to rounding), so if anything, the target would be even lower. But with quarter-point rounding in the funds rate target, the combined effect of these changes is not enough to change the result.
As to what the FOMC will actually do this week, I’ll go with the consensus of 25 basis points. As Mark Shivers suggests, there are persuasive arguments to be made for either 0 or 50, and the arguments are sufficiently persuasive that neither of these options can be chosen, because either one would imply a strong rejection of the other. Although the financial crisis has clearly diminished, it may not have diminished as much or as quickly as the Fed had hoped, and part of the reason for its diminishing is the expectation of another rate cut. Depending on how you read the beige book, there either are or aren’t indications that the crisis is affecting the real economy, so the appropriate rate cut is either 50 basis points (to nip this trend in the bud) or 0. An individual might make the choice by flipping a coin, but a committee makes it by splitting the difference.
As for my serious opinion of what the FOMC should do, I think I would go with 50. A 75 basis point cut would risk too much financial market (and foreign exchange market) instability, but even a more conservative Taylor rule would call for at least 50. (Say, for example, we reduced the target inflation rate from 2% to 1.5% and increased the natural real federal funds rate from 2% to 2.5%. That would increase the target funds rate by 75 basis points, leaving 50 still to go. Personally, I’d rather stick with the original rule if we’re going to use Taylor rules at all, but I’m open to choosing a higher inflation reading than my 1.6%.) Some of the arguments I made in September no longer apply (e.g. the temporarily robust dollar, falling employment), but most of them still do, and the bottom line is that even 4.5% qualifies as a slightly restrictive policy, not appropriate when the core inflation rate is still low and 65% of Americans expect a recession (hat tip: Barry Ritholtz).
I could also point out that, while the financial crisis has diminished, the underlying housing problem has gotten worse (and by worse I mean worse relative to expectations). Here in eastern Massachusetts (home of the world champion Boston Red Sox!), where a year ago it was difficult to find anecdotal evidence to support the statistical finding that house prices were declining, it is now difficult to avoid the anecdotal evidence. At dinner Saturday evening, for example, the waitress told my wife about how she and her husband were planning to move but underwater on their mortgage and hoping the bank would accept a short sale. With the personal savings rate still near zero, declining house prices are likely to be a drag on consumer spending for quite a while, and the risk that the we could discover a nonlinearity in the response sometime soon – particularly with oil prices making new record highs and credit conditions fairly tight – is palpable. When and if we hit that nonlinearity, it will be too late to prevent a recession.