Why the Fed Hung Tough


While many investors hoped for more, the Federal Reserve trimmed interest rates by a quarter-point and kept a keen eye on inflation

Fears of a coming recession are running so high on Wall Street these days that most traders have forgotten about the other risk facing the economy—inflation. But inflation remains very much on the minds of the voters on the Federal Open Market Committee. That's why, on Dec. 11, the Fed cut rates by less than many traders had hoped and refused to signal more cuts were on the way.

The Dow Jones industrial average fell 197 points, or 1.43%, just minutes after the Fed's statement at 2:15 p.m. Eastern time. The broader Standard & Poor's 500-stock index fell 24 points, or 1.59%.

The Fed rate-setters cut the target for the federal funds rate, which is the rate on overnight loans of reserves between banks, to 4.25%, from 4.5%. They cut the discount rate—the rate on direct loans by the Fed to banks—to 4.75%, from 5%. While the fed funds reduction came in as widely expected (if maybe not desired), many traders had been hoping for a bigger cut in the discount rate.

Who's Worried About Inflation?

Why the bearish reaction (BusinessWeek.com, 12/11/07) on Wall Street? Easy. Stock investors love lower interest rates because they stimulate economic growth and corporate profitability, while lessening the attractiveness of bonds as an alternative to the stock market. They were disappointed when the cut in the federal funds rate merely met expectations, rather than exceeded them.

And inflation? Well, stock investors don't mind inflation as long as it doesn't get too far out of control. Inflation is much more of a problem for owners of bonds and other fixed-income securities. So Wall Street gets steamed when the Fed wages war on inflation by keeping rates higher than traders would like.

A Carefully Worded Statement

The Fed had plenty of opportunities to signal it was ready to cut again, but didn't take them. Here are some excerpts from the carefully worded statement:

"Today's action, combined with the policy actions taken earlier, should help promote moderate growth over time."

"[T]he Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully."

"The Committee will…act as needed to foster price stability and sustainable economic growth."

A footnote: Eric Rosengren, a new member of the Federal Open Market Committee, dissented by voting for a half-percentage-point cut in the federal funds rate, to 4%. Rosengren joined the FOMC when he became president of the Federal Reserve Bank of Boston in July. But his dissent didn't seem to give much hope to the markets that the Fed was likely to become more dovish on inflation.

Coy is BusinessWeek's Economics editor.

We Almost Lost the Nasdaq
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