Bernanke’s Bind

A great deal of ink has been spilled on yesterday’s 50 basis point cut in the Fed funds rate and parallel reduction in the discount rate. I am very time stressed, so this quick reaction will (hopefully) be followed by a more thoughtful piece in the next day or so.

First, even though I think this is a decision we will all come to regret (see Jim Rogers’ and Marc Faber’s views), it’s important to recognize that the Fed was in a no-win situation. It is in the awful position of having responsibility without authority. Large parts of the credit markets are beyond the Fed’s purview. For example, only 15% of the non-farm debt in the US is held by US financial institutions. Even worse, the lack of regulatory reach means the central bank has at best only peripheral information about what the other 85% is up to.

Moreover, the data that came in last two weeks – lousy job creation, seemingly reduced inflationary pressures, weak retail sales, rising foreclosures – made it well nigh impossible for the Fed to just say no. As we have become intolerant of wars that involve body counts, so to have we become unwilling to have economic activity that involves recession. “Recession” is now as feared and loathed ad “depression” was a generation ago.

Second, it is likely that any Fed action will be futile. The underlying problems are beyond the ability of a liquidity fix to solve. We have substantial inventory overhang in the housing market, worse than in 1988, combined with record high rental vacancies. Yes, around the margin, cheaper interest rates can turn insolvent borrowers into viable ones, but the scale of this problem is far greater than that. More liberal credit will not solve a problem of oversupply and prices that are out of line with incomes and vacancies. Plus no matter what happens to rates, banks do not become more generous with mortgage approvals when foreclosures are rising. Nor will more liberal credit make investors less worried about counterparty risk.

Third, Bernanke’s refusal to signal his intentions, and the fact that other Fed officials who spoke last week gave divergent views, had the effect of lowering the market’s expectations (one might say demands) for a cut from 50 to 25 basis points. That was an opportunity squandered, unless you believe that the Fed really is very worried about the downside (which means the stock market rally is badly misguided) or the Fed was playing tactically than strategically. As the Financial Times’ John Authers asserts:

Taken together, this package was more aggressive than almost anyone had expected – and truly extraordinary given that only six weeks ago the Fed was still saying that its “predominant” concern was inflation….

The Fed did this for reasons of game theory. They did not want to cut rates at all. But the credit squeeze meant they had to act. Therefore, the logic went, it made most sense to act drastically and take the market by surprise. That maximised the chance for their action to have the desired effect.

I hope Authers is right, but that sort of thinking is the logic of a trader or a politician. Bernanke is neither. Either he is a spectacularly fast learner or something else is at work. Barry Ritholtz summed up downside for the Fed:

They have become Wall Street’s bitch.They may find that’s a difficult condition to wriggle out from . .

Update, 9/19, 8:15 AM: A good observation from Dean Baker:

The coverage of the Fed’s half point cut in interest rates yesterday highlighted the enthusiastic response of the market….

As some articles noted, this cut bears a resemblance to the Fed’s 0.5 percentage point cut in January of 2001 at an unscheduled emergency meeting. That cut also led to a very enthusiastic response from Wall Street. The Dow rose 2.8 percent following that cut and the Nasdaq jumped by a record 14.2 percent. ….

It did continue to cut interest rates, lowering the federal funds rate by a total of 5.5 percentage points to 1.0 percent, the lowest rate since the mid-fifties. However, this rate cutting did not prevent the economy from falling into a recession…. In spite of the Fed’s aggresive rate cutting,the economy remained so weak that it took four full years to once again reach the employment levels of February 2001.

The lesson from the 2001 experience is that cutting interest rates is not necessarily a very effective tool in counteracting the impact of a collapsing asset bubble. My guess is that rate cuts will provide even less effective stimulus now than they did in 2001, primarily because they will not reverse the decline in house prices and the wave of defaults and foreclosures that will follow.