Economics & Research Blog
The Fed Blinks
By Dr. Joe Webb
Published: August 17, 2007
(This note has been revised and extended from its initial posting this morning at about 8:45am -- JWW 12:26pm EDT)
The Federal Reserve cut its discount rate (and not the Fed funds rate) by half a point. For a while I have been saying that they had overtightened, and now they cut one of their rates in the worst kind of environment rather than in their usual measured way. They basically met the marketplace halfway, giving them another shot at liquidity without fully lowering their interest rates.
They may have felt that the excesses of lenient lending practices came out of the system. They just came out all at once.
One of the factors may have been the fear of political pressure of Congress hearing from thousands of homeowners facing significant rises in their interest payments. This sidesteps the issue, and it potentially avoids regulatory cures that would have been worse than the problem. While this does not offer an immediate solution to mortgage markets, it at least lets the entire credit system begin to unwind (and not unravel) in a somewhat better way than it has in the last week or so. Economics is always an understanding of indirect effects, two, three, and four steps after the immediate effect of an action. This is, essentially, a bandage. Almost immediately, the yield curve slightly "un-inverted." That is, long rates became higher than short rates. The Fed can only impact short term rates, and the way that they do is indirectly through its operations and the activities of the banks that use them. Just last week, we had a Fed statement that they were watching things, but overall the nature of markets were nothing that they already weren't working through.
Their statement issued this morning was as follows:Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.
This means that they will potentially act again, and very soon. More comments next week.