Tuesday, January 22, 2008

Blink, jump, fish or cut bait? 

During my next-to-last segment on KNSI this AM we got word that the Federal Reserve had cut the Fed funds rate by 75 bp. Admittedly, that got me excited; I have been wracking my brain looking for similar cuts. Most seem to focus on the 50 bp cut in April 2001 which, James Hamilton notes, turned out to occur one month after the business cycle peak.

(Wouldn't you know it? My letter to the editor on the question of Minnesota's recession and some rather sensational comments from our local editor was just accepted last night. Had I waited two days, maybe I write something different.)

I like what Paul Krugman says here regarding Bernanke's study of the dithering of the Bank of Japan and the long malaise that followed its bubble. It does argue for the Fed to move very quickly. Some have pointed out this paper Bernanke wrote with Kenneth Kuttner in 2004 in which they found substantial effects from pre-emptive cutting in the U.S. on the stock market. In the 2001 case, the Fed cut rates about four weeks before a regular FOMC meeting, and then cut another 50bp at the meeting. (On October 15, 1998, they did an intermeeting cut of 25bp and then followed with another 25 at the regular meeting on November 17.) So it seems most likely the Fed would cut again next week.

I'm reminded though of another, more famous paper that Bernanke wrote with Michael Woodford more than ten years ago (link goes to a draft copy at NBER -- the actual paper was eventually published in the Journal of Money, Credit and Banking.) Alan Blinder discussing it later in his Quiet Revolution refers to them emphasizing "the imporatance of the central bank using its own inflation forecast rather than relying on the market's, which, in the context of their model, is the only way the bank can maintain its independence from the market." (p. 74) Without it, the market cannot find a unique equilibrium. We do not permit the Fed to be independent of government just to become a slave to financial markets; the reason they get independence, Blinder argues, is that we want central bankers to have longer time horizons. If the Fed always tries to stall the bear whenever it roars, it eventually creates instability.

It's worth noting that the move wasn't unanimous, as noted inflation hawk William Poole dissented from the majority. In a speech he gave last September, Poole argued that while recessions are important, they aren't prevented by adding to inflation.
A central bank cannot fix the level of employment or its rate of growth, or the average rate of unemployment. However, the central bank can contribute to employment stability. Avoiding, or at least cushioning, recessions is an important goal. This goal should not be viewed as in conflict with price stability. The most serious employment disaster in U.S. history was the Great Depression, which was a consequence of monetary policy mistakes that led to ongoing serious deflation. Similarly, the period of the Great Inflation saw four recessions in 14 years. Price stability is an essential precondition for overall economic stability.

I believe that part of the policy strategy ought to be to convey as clearly as possible to the market what the central bank is doing and why. A policy strategy that is a mystery to the markets will not serve the central bank well. (p. 6)
If the move had been inflationary, I thought we would see a rally in commodities, but so far it has not happened (save for gold.) So while I thought the move was quite a pre-emptive strike (had I not been on-air I might have issued Dan Drezner's words), so far it appears the Fed is on the right side of stabilization so far. Maybe they have it right that inflationary expectations are "reasonably well-anchored" and I'd like to think, as Hamilton did, that the Fed has just said it sees a recession, but this post on the Fed's own model's probability of recession -- less than 50-50 -- fits mine, and I think I would have voted with Poole if anyone bothered to ask me. Not that they should.

It would be highly unlikely in this environment for the government to stop the rush to stimulate. Peter Orszag reviews the evidence presented at the Senate Finance Committee meeting today. You do wonder, don't you, how things appear to require such drastic measures in the USA while things are so good elsewhere?

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