The Federal Reserve makes a bold cut in interest rates

The Federal Reserve makes a bold cut in interest rates

By : economist.com

Republish : Zulfikar, ST

IS THE Federal Reserve running scared of the financial markets—or the housing market? On Tuesday September 18th America’s central bank cut its target for the federal funds rate by half a point, to 4.75%, the first reduction for more than four years. Financial markets had thought a quarter-point cut a shade more likely, but prayed fervently for a half. Rejoicing, the S&P 500 jumped by nearly 3% after the Fed’s announcement and the Dow Jones index closed more than 300 points up.
Once the cheering stops, it may be worth reflecting on what the Fed’s action—and words—say about the state of the economy, especially the housing market. The “tightening of credit conditions”, said the Fed, “has the potential to intensify the housing correction and to restrain economic growth.” The Fed seems to be trying to act before things get worse: the cut, it said, “is intended to help forestall some of the adverse effects on the broader economy”.

This argument is close to that laid out by Frederic Mishkin, a Fed governor, at the Jackson Hole central bankers’ symposium a fortnight ago. If a central bank cuts rates swiftly, Mr Mishkin argued there, it can soften the effects of even a sharp drop in house prices—not least because falling house prices translate only slowly into lower spending. The arguments of Janet Yellen, head of the San Francisco Fed, also seem to have been persuasive, says Adam Posen of the Peterson Institute of International Economics in Washington, DC: “the San Francisco Fed is one of the only regional Feds to have independent full-scale forecasts”. She gave warning this week that “financial market turmoil seems likely to intensify the downturn in housing”.

The Fed will have been helped towards its half-point cut by benign data on both consumer and producer prices: the latter, released on the day of the Fed’s decision, showed a 1.4% fall in August. More bad news from the housing market, published the same day, will have added weight to the argument for a bigger cut. An index of homebuilders’ confidence fell to match the lowest level reached since its inception in 1991. And the rate of foreclosures has more than doubled in the past year.
To some, it will seem as if the Fed has caved in to Wall Street. The emphasis on the housing market may help to dispel that impression. So might the Fed’s insistence that “some inflation risks remain” and that it will “continue to monitor inflation developments carefully.” So too, notes Mr Posen, will recent data on inflation, housing and jobs. Even so, the Fed will have to keep choosing its words carefully in the months ahead.