“The past is never dead. It’s not even past.” – William Faulkner
FAULKNER’S observation could easily apply to the Federal Reserve’s recent move to stimulate the US economy and stem the precipitous downturn in many stock markets around the world.
On Tuesday, the Fed announced it was dropping the prime lending rate by three-quarters of a percent – the largest rate cut in more than 20 years. It also signaled that yet another rate cut is all but certain next week.
It’s a bold response – but not necessarily a wise one. The danger is that the Fed may be poised to repeat mistakes that helped create the current economic slowdown.
There’s no damage done yet. The US stock indexes escaped the bloodbath that drenched much of the world on Monday – because our markets were closed for the Martin Luther King holiday, and when they reopened Tuesday, Fed Reserve chief Ben Bernanke calmed their jitters right off the bat with the unscheduled and unexpected rate cut.
Why does the stock market like interest-rate cuts? Because the Fed’s cuts lead to cheaper credit. Lower interest rates help more prospective home-buyers find affordable mortgages, encourage consumers to buy high-ticket items like cars and appliances and make it easier to finance business expansions and takeover deals.
The Fed hopes that its move will stimulate the financial and lending sectors that have been paralyzed by the housing mess. It also wants to reassure banks and markets that it is taking strong action to help the economy and the stock market.
But the Fed deserves some blame for the housing crash that brought on this downturn. Earlier in the decade, the Federal Reserve made credit too cheap – and so fueled speculation in the housing market. In the go-go atmosphere, lending institutions made bad loans, and borrowers made bad decisions by investing in “innovative” types of low-rate mortgages made possible by the Fed’s low rates.
Speculative bubbles always end poorly, and the housing bubble is no exception. But it’s usually better to get the pain over with – to let asset prices fall to more realistic pricing levels without intervention. Trying to prop up prices – to keep the bubble inflated – via financial manipulations or bailouts nearly always just spreads the pain over a longer period of time, hindering the economy’s recovery. The Fed must be careful not to cut rates so aggressively that it repeats its earlier mistakes.
Excessive rate cuts entail other risks. For example, the dollar was already weak – and now will fall further against foreign currencies. That’s good for exporters, but not for those hoping to attract foreign investment.
But there’s a more serious threat – inflation.
Last year, the consumer price index rose 4.1 percent, with core inflation (excluding food and energy costs) up more than 2 percent. Economists consider both numbers to be close to, if not above, the maximum comfort level. Normally, such numbers would make interest-rate hikes more likely than the cuts the Fed is giving us.
By slashing rates, the Fed shows that it feels a sharp economic downturn is a greater danger than inflation. That may not be the right call. It’s an especially perilous judgment – because long-lasting high inflation can be far a larger and more difficult economic problem than a short recession. That’s why holding the line on inflation is often deemed the Fed’s most important job.
Finally, the Fed’s unexpected action may end up alarming, not calming investors. Deep and rapid rate cuts may be interpreted as signs that the Fed believes the economy is worse than many realize. After Tuesday, many analysts are reassessing the iceberg to see how bad things are underneath the surface.
Both the federal government and the Fed are acting as if the US economy is already in a recession, but the Congressional Budget Office doesn’t believe a recession will occur this year. There are a few positive economic indicators, and we so far haven’t seen a downturn in employment.
While Tuesday’s large rate cut may have been necessary, given the panic in world stock markets, future cuts could be too much of a good thing. The Federal Reserve should be more concerned about inflation than protecting stock markets.
Sometimes the best cure for a hangover is just a hangover – and not hair of the dog.
Rea Hederman is assistant director of The Heritage Foundation’s Center for Data Analysis.