EUR/USD Unaffected By FOMC Decision

September 16, 2008

The FOMC did even less than today’s Wall Street Journal (planted?) story implied.  Rates were not cut, nor was the risk bias shifted from neutrality to flagging a possible need for more ease.  For the record, officials remains significantly concerned about the future possibilities of both too little growth and too much inflation, although the baseline forecast foresees moderate economic growth returning and moderating inflation.  Saying the economy will be alright or that it is fundamentally sound doesn’t make it so.  Japanese officials tried that for a whole decade in the 1990’s and fooled hardly anyone, and the most famous instance of a failed strategy of official cheerleading was how Herbert Hoover handled the onset of the depression.

While I remain skeptical that the Fed can avoid easing, the immediate reaction of markets to no cut in rates or change in the risk statement has been better than I would have thought.  Some 2-1/2 hours after the announcement, the euro has barely moved, and the dollar has recouped 1.0% against the yen, which has become a barometer of risk aversion.  Oil is nearly 2% firmer, and 10-year Treasury yields, which were extremely low at the time of the announcement, jumped up 15 basis points.  The DJIA and Nasdaq closed 1.1% and 1.4% above their levels at 18:14 GMT.

The part of me that doesn’t like to see central banks cave into the demands of market panic is thinking bravo.  But more important than winning a game of chicken concerns whether officials made the right call.  I’ve felt for some time that 2.0% ought to be more than low enough, being set against consumer price inflation of 5.4% and second-quarter growth of more than 3.0%.  In fact, 2.0% appeared too low for officials to return policy to neutrality in a timely manner when the time for that arrives.  Interest rate changes are not a good way to get liquidity into the hands of the institutions and people, who really need it.  Many of the other policy innovations of the Fed seemed better suited for addressing the credit crunch.  But then came the jaw-dropping developments of this past weekend and yesterday.  One school of central bank strategising maintains that policy should protect against the scenarios that could do the most damage and not simply be guided by most-likely outcomes.  Financial market upheavals do not always herald ruptures in the real economy, as we saw when the October 1987 stock market crash was not followed by an economic slowdown or further equity price erosion.  One cannot be certain that the weekend events mean a substantially weaker U.S. economic and inflation outlook to warrant a rate cut, but that clearly is a danger.  If future economic trends and developments point more clearly to that danger, monetary relief will come.  But if that is necessary, it would have been better to cut rates now than for policy to be more reactionary.

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