Yes, the Federal Reserve handed out the monetary candy that the markets were expecting on Halloween, a quarter-point cut in the federal funds rate target to 4.5% from 4.75%. No, it wasn't an easy decision. Central bankers are notoriously reluctant to cut rates too far, and the latest easing has at least the potential to overstimulate an economy that's already running at a brisk pace.
How close a call was it for the Federal Open Market Committee? One indication is that one voter, Thomas Hoenig of the Kansas City Fed, dissented from the cut, voting to leave rates unchanged. And the entire committee made it clear that further cuts aren't baked into the cake. It said "some inflation risks remain," and added, "after this action, the upside risks to inflation roughly balance the downside risks to growth."
The Market Takes the Cut in Stride
The financial markets would have reacted with horror if the Fed had left rates unchanged, but they showed little reaction to the announced cut. They were primed to expect a cut, so there was relatively little reaction to the announcement, which came shortly after 2 p.m. on Oct. 31. Stocks actually retreated a bit from their daily highs, probably in reaction to the "no" vote from Hoenig and the accompanying Fed statement. The Standard & Poor's 500-stock index was up just 0.2% minutes after the announcement, after having been up 0.8% earlier in the session.
Jeoffrey Hall, chief U.S. economist for Thomson Financial (TOC), said he didn't think a cut was necessary. "It may be the tip of the spear, but we're not really seeing the profound impacts on the economy from the acute crisis in the financial sector," Hall said. On the other hand, he said, market expectations of a cut were so strong that the Fed would have risked a sharp sell-off in financial markets if it hadn't met those expectations. Says Hall: "They don't want to shock markets in a negative way."
In its Halloween announcement, the Fed seemed a bit like a parent who's afraid of handing out too many candy bars. To critics, cutting rates seems unnecessary and perhaps even dangerous in light of the combination of healthy economic growth and inflation threats. On the morning of the Fed's announcement, the Commerce Dept. announced that the U.S. economy grew at an estimated annual rate of 3.9% in the third quarter. That was well above economists' forecasts of about 3%, which itself was considered a healthy number. Exports of goods grew at their fastest pace in a decade, economic research firm Global Insight points out. And consumer spending rose at a 3% annual clip. Even if this early estimate gets revised downward somewhat, it doesn't seem to describe an economy that's stumbling into an open grave.
Housing Trumps Inflation Worries
Inflation is the other factor that must have caused Fed policymakers to pause before cutting. Oil is at around $90 a barrel, causing gasoline prices at the pump to shoot higher. And the U.S. dollar has been losing ground, reaching record lows against the euro, for one. A cheaper dollar raises prices of all imports. Keeping a lid on the witch's cauldron of inflation is the Fed's No. 1 job.
Then why cut? In a word: housing. The slump in the housing market is so severe that it still threatens to drag down the rest of the economy. Housing's crash has multiple impacts: throwing homebuilders out of work; making homeowners feel poorer and less willing to spend; and threatening a generalized credit crunch by casting doubt on the value of subprime mortgage-backed securities. What's more, the housing crash isn't over, judging from the mounting inventory of unsold homes. Global Insight, in a report issued before the Fed's announcement, wrote, "We expect the damage to come through soon, with gross domestic product growth slipping to just 1.5% in the fourth quarter, and doing no better than that in the first half of 2008."
As for inflation worries, upward pressure on prices may become a problem but there's not much sign of it yet. In fact, the Commerce Dept. estimates that prices rose at an annual rate of just 0.8% in the third quarter, the smallest gain in nine years. Here's what the Fed said on the subject: "Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation."
Sum it up, and the Oct. 31 cut seems to be a precautionary measure. In other words, the Fed may have judged that the risk of cutting too much (and overcharging the economy) was smaller than the risk of cutting too little (and bringing on a recession). Think of it like carrying a clove of garlic on a pitch-black Halloween night: While there may not be any vampires coming your way, it's still nice to have it at the ready.