Fed Talk: The Half-Percent Solution?

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Housing is the most interest-rate sensitive sector of the economy, and in times past it would receive a quick boost from monetary easing. The troubled mortgage securities market is short-circuiting this boost today. The issuance of bonds backed by subprime, alternative-A, and jumbo mortgage loans has collapsed. Save for conforming fixed-rate loans, which are only loosely tied to Fed actions, lenders are unable and unwilling to extend mortgage credit to all but the most pristine borrowers at any interest rate.

Bernanke's "Accelerator"

Ed Yardeni, president and chief investment strategist, Yardeni Research: So will the FOMC cut by 50 basis points on Wednesday? I think so. If they don't, "sell now" might be better advice. Yesterday's Financial Times noted the Fed is expected "to ram home its new aggressive approach to fighting the risk of a protracted U.S. recession with a further interest rate cut…." My friend Peter Hooper of Deutsche Bank told the FT the Fed has built up expectations of a 50 basis points cut through the statement that accompanied the emergency 75 points cut. The statement said "appreciable" downside risks remained even after the Big Easing last week and promised "timely" action. Not a single Fed official has guided us to expect less than 50 basis points.

Yesterday, Greg Ip, the Wall Street Journal's Fed-watcher extraordinaire, highlighted a speech delivered by Ben Bernanke last June on the "financial accelerator." According to this theory, which the Fed chairman developed along with Mark Gertler of NYU in the 1980s, weakness in the financial system can compound an economic downturn. Apparently Mr. Bernanke now believes the economy's weakest links are in the financial system and that very stimulative monetary and fiscal policies are essential for avoiding a meltdown. He has been behind the curve, but he is catching up fast.

Fed Should Stand Pat

Ken Kim, economist, Stone & McCarthy: The Federal Reserve has placed themselves in a predicament. If the Federal Open Market Committee were to meet six weeks from now, we think it would have been a fairly easy Fed call, a 1/2% reduction in the federal funds rate target. However by cutting the federal funds rate by 3/4 of a percentage point to 3.50% last Tuesday, that complicates matters given that policymakers meet again this week to decide the course for interest rates.

Not that it was the wrong move but should the Federal Reserve reduce rates by another 1/2% this week, as fed funds futures markets imply, that would be 125 basis points of easing in roughly a week's time. That is simply shocking. How shocking? Not even Alan Greenspan initiated a cut in the federal funds rate by 75 basis points at an FOMC meeting, whether scheduled or unscheduled, and that was in a disinflationary environment as well. Greenspan also guided the U.S. economy through two recessions and never cut the federal funds rate by such an amount.

As difficult as it may seem to our readers, we believe the FOMC should keep interest rates unchanged at this week's FOMC meeting. As you know, we have been forecasting policy accommodation since last summer and we have not changed our view. We continue to believe the federal funds rate will move lower in the months ahead. However, with the scheduled FOMC meeting coming so soon after the substantive reduction in interest rates last week, we believe the Federal Reserve should meter its dosage of interest rate cuts.