The Fed's decision to cut interest rates to a 45-year low of 1% despite an upbeat economic assessment reveals a lack of genuine confidence
The average person might be confused by the discrepancy between the Federal Reserve's words and deeds. He shouldn't feel bad; the professionals do not have much clarity either.
The Fed lowered its benchmark overnight interest rate by 25 basis points on 25 June to a 45-year low of 1%. The action was accompanied by a more upbeat assessment of the economic outlook than the one presented at the prior meeting on 6 May, when the Fed opted for inaction.
So why did the Fed cut rates in the face of what it called 'a firming in spending, markedly improved financial conditions and labour and product markets that are stabilising'?
'The part about a firming of spending is a bit puzzling given that retail sales were soft and durable goods orders were down in May,' says Henry Willmore, chief US economist at Barclays Capital Group.
Not to worry. The Fed addressed the seeming inconsistency.
'The economy, nonetheless, has yet to exhibit sustainable growth,' the Fed said. 'With inflationary expectations subdued, the committee judged that a slightly more expansive monetary policy would add further support for an economy it expects to improve over time.'
The balance-of-risks assessment was a replica of May's 'split decision'. The outlook for growth was balanced while 'an unwelcome substantial fall in inflation' was seen as a greater probability than higher inflation.
Whereas in May the Fed managed to lift both bond and stock prices, this time it pleased neither master. Stocks fell and both short and long-term interest rates rose as the Fed appeared to lose its magical sway over the markets.
And it was not for lack of trying. The key sentence in the statement was intentionally loaded and came at the very end.
'On balance, the committee believes the latter concern (falling inflation) is likely to predominate for the foreseeable future,' the Fed said.
In other words, as far as Fed chairman Alan Greenspan can see, it is an overnight federal funds rate no higher than 1%.
The Fed's action and market response on 25 June and 6 May provide a timely test of a hypothesis proposed by Fed governor Don Kohn and Federal Reserve board senior economist Brian Sack in a new paper, Central Bank Talk: Does It Matter and Why?
After examining the impact of various forms of communication by the Federal Reserve, such as policy statements, testimonies and speeches, on interest rates and other financial variables, the authors conclude the effect of word and deed are in some cases interchangeable.
The Fed's statements 'have a sizeable and significant effect on near-term interest rates, including federal funds and the eurodollar futures rate, the two-year Treasury yield and Treasury forward rates out to two years,' the authors found.
The statement effect on short-term interest rates is no mystery. Because the Fed is essentially a monopolist, investors rightly assume the statement following a Fed meeting says something about the intent of policy going forward.
When it comes to congressional testimony on the economy and monetary policy, the effect extends 'much farther up the yield curve, with a significant response found even for the 10-year Treasury yield,' the study said. Kohn and Sack speculate the effect has to do with the informational content on the Fed's view of economic conditions.
Where Greenspan's comments hold no sway is on financial asset prices, according to the study. It feels as if Sack and Kohn, who was Greenspan's right hand for 15 years before becoming a governor last year, are attempting to exculpate the Fed for its role in the stock-market bubble.
'This finding is relevant to the argument put forward by some that the Federal Reserve could have damped the apparent stock market bubble of the late 1990s without actually adjusting monetary policy itself,' the authors write.
No one is suggesting anything of the kind. Some economists proposed raising margin requirements to rein in the debt-financed stock market boom, an option Greenspan dismissed as too blunt a tool. Many were critical of Greenspan's endorsement of a new era. No one I know of suggests he could have pricked the bubble with babble.
The Kohn/Sack paper is a worthy attempt to explore the effect greater central bank transparency could have in the implementation of policy.
Before that can happen, we need a Fed chairman who speaks clearly rather than obfuscating. We need a central banker who doesn't toss out theories at random to keep Congress happy and his critics at bay.
Bloomberg newsroom, New York
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