Saturday, August 14, 2010

Taking the Crisis Stance Too Far

The Fed “downgraded the U.S. economy” this week.

That was the way one television commentator put it, and that way of looking at it sums up the connection between the Fed’s monetary policy move and the stock market’s reaction.

It almost seems as if the Fed has forgotten that its monetary policy is in a crisis posture. In my opinion, any lending interest rate below 4 percent represents an adaptation to a crisis. Most economists disagree, of course, but there are very few observers who are able to look at interest rates below 1.25 percent and see anything other than a crisis. The difference between 4 percent and 1.25 percent is not as great as it might seem. If you do not want to borrow money at a 4 percent interest rate, then chances are, you do not want to borrow money at all. And the Fed’s target interest rate is not just slightly below this level. It is as low as possible. The Fed’s target interest rate is zero.

And now the Fed says it is easing. It is not lowering interest rates, obviously, but it would if it could. If the Fed is saying that its current monetary posture, already in crisis mode, is not enough to keep the economy going, then how can anyone expect stock traders and portfolio managers to bet on the U.S. economy right now? The Fed understands the economy better than most people making financial decisions, so its opinion carries some weight. It will hardly be surprising now if the stock market retreats by 10 to 15 percent from its recent peak, or if major employers move to accelerate the layoffs that are already on their to-do lists, or for that matter, if rating agencies follow suit and start downgrading government obligations and other financial instruments that depend on the U.S. economy.

This was a blunder on the Fed’s part. Economists may debate whether the monetary action has any impact at all, but there is no doubt that having an important government institution in crisis mode makes everyone uneasy. And there is good reason for being uneasy about extreme monetary easing. The low interest rates have a destabilizing effect, making it more likely that something in the economy will fall over without warning. When the Fed says it’s willing to risk this instability for quite some time to come, and indeed, to add to it, we can only assume that the Fed is extremely worried that the economy is falling apart. Bernanke might as well be running down Wall Street screaming, “Depression coming! Depression coming!” It would be safer, in my opinion, for the Fed to take more of an even-keel approach, speak optimistically, and hope for the best. But I am afraid it is too late for that now.