IN TAKING the bold step of cutting short-term interest rates by a half percentage point on Tuesday, the United States Federal Reserve has rolled the dice on what could prove a high stakes gamble.
In order for that bet to pay off, the Fed will need to see economic data prove weaker than what has come before. Otherwise, relatively solid data in coming months, joined with an assist from easier monetary policy, could risk a reignition of price pressures in an economy that is still beset by fairly persistent inflation gains.
To be sure, economists rate this threat as a relatively small one, and they support the idea of rate cuts. They point to recent economic data from the period before the recent market crisis that were already showing signs of strain. Financial markets still remain unsettled and represent a continued headwind to economic growth, in turn suggesting the real possibility that the Fed may have to cut rates again.
Still, a number of economists said in the wake of the Fed's decision to cut its target rate by 50 basis points to 4.75 per cent that the risk taken by central bankers is that the economic environment may not prove as weak as many currently fear.
Should various measures of economic performance turn out better than now projected, the heavy duty rate cut on Tuesday would serve as stimulant to growth and in turn re-stoke the embers of inflation. And the Fed itself hasn't stopped worrying about the issue, saying in its policy statement that "some inflation risks remain".
Incremental improvements in economic prospects will put more positive pressure on raw material prices, and other prices up the supply chain, which are already not low, noted Mr Ken Mayland, who helms forecasting firm ClearView Economics.
History suggests the Fed will again cut rates, he said. But he noted that in past cycles that have brought surprise rounds of rate cuts — the fall of 1998, as the Fed reacted to the shakeout at hedge fund Long-Term Capital Management — those easings have been quickly followed by tightening campaigns as central bankers have sought to put the inflation genie back in the bottle.
Indeed, after pushing the funds rate from 5.5 per cent at the start of September 1998 to 4.75 per cent by November of that year, the Fed was back to raising rates by June 1999, in a tightening cycle that ended in May of the following year, with the funds rate at 6.5 per cent.
In a speech last week, San Francisco Fed President Janet Yellen addressed the dilemma facing policy makers in the current environment. Current economic data don't yet reflect the woes that hit markets last month, complicating deliberations over what should be done with rates, she said.
But at the same time, "past experience does show that financial turbulence can be resolved more quickly than seems likely when we're in the middle of it".
So the risk the Fed faces is real. Still, forecasters said inflation worries need to be weighed against all the other troubles currently hitting the economy. With that in mind, few were concerned by the Fed's aggressive action.
"The economy looks to me like it's got a big weight around its neck from the housing recession," and credit market conditions are unlikely to normalise in the short term, said Lehman Brothers chief US economist Ethan Harris.
Relative to the experience of 1998, "it's a little harder to reignite the markets" via rate cuts right now, and thus the risk of the Fed restarting inflationary pressures is lower, he said.
And it bears noting that Fed chairman Ben Bernanke's views have been influenced by his studies on the Great Depression and what he sees as the central bank's role in exacerbating that downturn. Recently, he argued that the Bank of Japan may have not paid enough attention to the fallout of the bursting real estate bubble there.
Some of the concerns over the future course of events may be at the heart of why the Fed opted for the aggressive 50-basis-point cut. The last time an easing of that magnitude was in November 2002, and the tightening cycle that spanned June 2004 to June last year saw only quarter percentage point tightenings.
The size of the move on Tuesday means either "they are just trying to get out in front" of the trouble with a single bold move that may be all the central bank does, or "they are feeling more worried by things than we thought they were", said RBS Greenwich chief economist Stephen Stanley.
"The statement is not real clear" which is the likely explanation that in itself means Fed officials are likely making a play for flexibility while they watch the incoming data.
And it is the data that will be published from now until the Federal Open Market Committee meeting on Oct 30 and 31 that will make all the difference in determining whether the Fed went too far, or has more distance to travel, with its newfangled rate cut campaign. — Dow Jones
The writer is a Dow Jones special writer who has covered the Fed since 2001. He also covers bond markets and the economy.
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