Business | Investment
Fed up, or possibly Fed down? Your call
The first lesson of Fed history is that the US central bank can change course quickly when it has to.
- By Krishna Guha, Financial Times
- Published: 00:00 April 7, 2007
The first lesson of Fed history is that the US central bank can change course quickly when it has to.
On November 15, 2000, the Greenspan Fed declared "the risks continue to be weighted mainly toward conditions that may generate heightened inflation pressures". Seven weeks later, on January 3, 2001, the Fed cut rates by 50 basis points.
When the Bernanke Fed changed its statement this month, it was simply trying to show it did not have its head in the sand and could move fast if conditions deteriorate rapidly.
The second lesson is that changes in the Fed's policy bias offer a good guide to future rate moves. Policy-makers calibrate their stance as follows: rate rise, inflation bias, neutral stance, growth bias, rate cut.
The Fed hardly ever moves from an inflation or tightening bias - a bias it has today - to rate cuts in the space of a single meeting.
Bob Woodward reports that Alan Greenspan considered that a "triple move" on the policy spectrum and was unwilling to make it even in December 2000, when the US economy was in free-fall.
But the US central bank does skip one intervening step, going from a focus on inflation to a focus on growth without stopping at neutral, or from a neutral stance to a rate cut.
The third lesson is that the Fed can cut interest rates when inflation remains high, provided it is confident that it will fall in the future.
Different
The economic situation today is very different from late 2000-early 2001, when the stock market had plunged and investment was evaporating.
Today, house prices are flat nationwide year-on-year. Even if house prices do fall, consumption will not collapse as investment did in 2000.
A better parallel is between today and 1994-1995 - a mid-cycle correction in which the Fed overshot on interest rates and had to make three quarter point cuts over several months.
Today's Fed, though, is not sure the market is right. With unemployment at 4.5 per cent, the service sector still prospering, and little sign yet of serious spillovers from the crisis in subprime lending, policymakers still see a fair chance that growth will recover close to trend late this year.
Inflation is uncomfortably high, and with oil up again and inflation expectations inching higher, they are less confident that a fall in inflation is in the pipeline than in mid-1995. They worry that if inflation gets stuck at a high level, it will be more painful to force down.
The latest Fed statement that inflation remains the "predominant policy concern" is sincere: officials still do not expect to cut interest rates soon, even if they now admit that is possible.
History offers a good guide as to what the Fed will do if it realises it is wrong on growth. It does not tell us that the Fed has reached that conclusion.
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