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Whatever the other merits of the March rescue for struggling broker-dealer Bear Stearns, it has made Thursday’s rate-setting decision easier for the US Federal Reserve. Saving Bear reassured the markets: long-term interest rates and corporate bonds have strengthened, the dollar has stabilised. The result is that, while the Fed needs to pause soon, if it chooses to make one more 25-basis point cut in rates it is unlikely to cause a flight from the dollar or drastic inflationary risks.
The past month has brought a dramatic change in market expectations for interest rates over the next couple of years, without any dramatic change in Fed rhetoric. Yields on two-, five-, and 10-year Treasury notes have risen by 50bp or more. That has three implications. First, calmer markets mean there is less need for the Fed to reassure via interest rates. Second, the market’s view is that rates may not need to go below 2 per cent in the current cycle. Third, the rise in long-term market interest rates tightens overall credit conditions, and so creates scope to cut short-term rates.
The question for the Fed is whether another 25bp cut, to give a Fed funds rate of 2 per cent, strikes the correct balance between the remaining risk of a deep recession and the risk of prolonged inflation.
There is no doubt that the risk of a bad recession remains. Consumer confidence is awful, Wednesday’s Case-Shiller index showed an accelerating decline in house prices, and joblessness had begun to creep upwards. The dynamics of a recession – falling house prices that mean less borrowing and so further falls in house prices, falling confidence that causes lower consumption and investment and so lower confidence – have not been reversed.
On the other hand, the Fed will have to weigh a number of government measures to boost the economy. The effects of the fiscal stimulus, which will soon be felt, can be estimated. The effects of more dramatic schemes to boost the housing market, which may soon emerge from Congress, are less predictable and are one reason to delay a cut until the Fed’s June meeting.
Inflation risks remain: if financial markets continue to improve rapidly while commodity prices march upward, there is a danger of triggering expectations of higher inflation. For that reason it would be better for the Fed to remain on hold this time, observe the effects of the medicine it has already administered and see what the government does next. Thus far, however, the Fed has pulled off an aggressive monetary policy with some success. If the Fed judges one more cut is needed, it deserves the benefit of the doubt.