It is bad news when the markets panic. It is worse news when one of the world’s key monetary policy making institutions panics. Today the Fed cut the target for the Federal Funds Rate by 75 basis points, from 4.25 percent to 3.50 percent. The announcement was made outside normal hours and between normal scheduled FOMC meetings.
This extraordinary action was excessive and smells of fear. It is the clearest example of monetary policy panic football I have witnessed in more than thirty years as a professional economist. Because the action is so disproportionate, it is likely to further unsettle markets. Even the symptoms of malaise that appear to have triggered the Fed’s irresponsible rate cut, the collapse of stock markets in Asia and Europe and the clear message from the futures markets that the US stock markets would follow (a 500 point decline of the Dow was indicated), are unlikely to be improved by this measure and may well be adversely affected.
In the absence of any other dramatic news that the sky is falling, I can only infer from the Fed’s action that one or both of the following two propositions must be true.
- The Fed cares intrinsically about the stock market; specifically, it will use the instruments at its disposal to limit to the best of its ability any sudden decline in the stock market.
- The Fed believes that the global and (anticipate) domestic decline in stock prices either will have such a strong negative impact on the real economy or provides new information about future economic weakness from other sources, that its triple mandate (maximum employment, stable prices and moderate long-term interest rates) is best served by an out-of-sequence, out-of-hours rate cut of 75 basis points.
The first proposition would mean that the Fed violates its mandate. The second is bad economics.
This panic reaction is destabilising in the short run because it is likely to spook the markets. When the Fed loses its nerve, "things fall apart; the centre cannot hold". In the medium term it subordinates the price stability target to the real economic activity target. It also lays the foundations for the next credit bubble, after the recession of 2008 has become a distant memory.
It would have been far preferable, particulary because the stock market decline is a global phenomenon, to have a coordinated modest rate cut of, say, 25 basis points, by all leading central banks at some later date, when this would not look like a collective knee-jerk response to a fall in global equity prices.
With this irresponsible act, the Fed has just become part of the problem. Interesting times indeed.