Eyes back on Fed for emergency rate cut
Peter Morici

United States stock markets were lifted on Tuesday on speculation that Federal Reserve chairman Ben Bernanke will call an emergency meeting of the Fed to further cut interest rates, contrary to warnings by policy makers in the past two weeks. The speculation was fueled by the Fed's first set of quarterly economic forecasts, a product of the new regime recently instituted by Bernanke.

The degree of "uncertainty'' about the growth outlook is greater than that for inflation, Fed officials said on Tuesday. While they expressed confidence price increases will ease, they viewed markets as "still fragile and were concerned that an adverse shock'' would worsen economic risks.

This is a remarkable turnaround for Bernanke.

On October 31, the Fed cut the Federal Funds rate a quarter point to 4.50% but essentially said that it would not likely cut rates further. The Federal Open Market Committee (FOMC) stated: "The committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth."

Since that time, virtually all the economic news has been bad. Wall Street firms are taking mega-write downs on subprime debt (and Freddie Mac, the government-chartered mortgage funding giant, announced a $2 billion quarterly loss on Tuesday), the stock market has tanked, retail and housing sales are in the sink, commercial real estate values are falling, and industrial production is contracting.

It seems the Fed is under pressure every few weeks to change course on policy. After telling us the subprime crisis was under control, both Bernanke and Treasury Secretary Henry Paulson gave speeches on October 15 and 16, explaining why exceptional action would now be required to rework adjustable rate mortgages, re-establish mortgage markets, and ensure general liquidity for the conduct of business.

Which is it Ben: Are we in trouble or aren't we?

We are!

The US economy is delicately walking along a precipice between much slower growth and a tough recession. If the housing "adjustment" turns into a rout, it will be too late for the Fed to cut interest rates enough to save the economy from a bad episode of stagflation - rising unemployment caused by evaporating household wealth and oil driven inflation.

Yet, the Fed seems at sixes and sevens on all this for five reasons.

First, the Fed has failed to grasp how the damage in the subprime market to the balance sheets of Citigroup, Merrill Lynch and others have damaged fundamental confidence in Washington's economic management and undermined the resilience of the US economy.

We have been suffering a crisis of confidence for many weeks, and the Fed doesn't get it. If it did, the Fed would not have precluded further action in its October 31 statement.

Second, unlike the European Central Bank, Fed policymaking primarily focuses on short-term interest rates and not money supply management. In large measure, the US dollar's international status as the reserve currency - other central banks use dollar holdings to back up their currencies - makes both the supply of US money and its impact on inflation unstable and difficult to manage.

The practical problem is that money is liquidity, and important segments of the US economy are suffering from a liquidity crisis.

Third, the Treasury and Fed have failed to come to terms with the impact of China on US monetary policy. China's policy of undervaluing the yuan and buying massive amounts of dollars and securities, to keep down the prices of the yuan and its exports on US store shelves, has significantly unhinged US short-term interest rates from US mortgage and other long-term rates.

Fifth, the Treasury and Fed have failed to come to terms with the corrosive consequences on bond, mortgage and wider credit markets of self-dealing at Standard and Poor's and other bond rating agencies. No one is going to buy many private US securities as long as rating agencies are paid by Wall Street bankers who appear able to manipulate the process.

In the near term, the Fed needs to help avert complete meltdown in the housing sector by bringing down long rates. It should buy Treasuries on the long end of the yield curve, as well as ensure adequate and affordable liquidity in the short-term, commercial credit market.

Immediately, the Treasury and Fed should come out for sweeping changes in practices, management and governance at Standard and Poor's and other bond rating agencies.

Given the special status that bond rating agencies enjoy in certifying investments for pension funds and other public purposes, these changes should be more sweeping than those under way at Merrill Lynch and Citigroup. To emphasize the point, the senior management at the rating agencies should not be permitted to leave as cynically enriched as did Stan O'Neal at Merrill and Chuck Prince at Citigroup.

Peter Morici is a professor at the University of Maryland School of Business and former chief economist at the US International Trade Commission.

Copyright 2007 Peter Morici

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