How to Cushion the Cost of the Right Decision

Op-ed in the Financial Times

January 29, 2008

Now that the Federal Reserve is easing aggressively and is committed to being ahead of developments, the challenge is how to mitigate the resulting costs.

There will be costs even though, on balance, the Fed is clearly doing the right thing. The Federal Open Market Committee (FOMC) should be taking action to manage the impact of its interest rate cuts, not just deciding the size and timing of the cuts to come.

The most obvious cost to consider is that inflation will rise. The main determinant of inflation is not recent financial events or even oil prices-it is that the US trend productivity growth rate has come down since 2000-2005, so that even more modest growth rates will cause inflationary pressures. Also, the inflationary impact of a weakening dollar, although lower than it used to be, is not zero, especially when the currency adjustment is large and sustained for long enough to induce price adjustments by exporters.

There is no reason to think that large declines in real estate prices will have a significant negative effect on the general price level (if they had on the way up, there would not have been a monetary policy dilemma of a bubble without inflation). If my own (and still the consensus) forecast for only two or three quarters of slow growth and no real recession is correct, and thus these interest rate cuts, plus the announced fiscal package, are ample stimulus once the financial spillovers are contained, we are looking at pretty high inflation forecasts from 2009. That should not prevent the Fed from acting now to preclude the risk of a costly downward spiral but it means the inflation risk of doing so will be realized.

The Fed also suffers a loss of credibility from doing the right thing now. However, moral hazard is neither large nor persistent enough legitimately to prevent Fed easing. Most people with shares in financial companies are losing plenty of money, some employees of those companies will lose their jobs and it is not worth putting the entire economy through the wringer just to teach a bunch of thick-necked 30-something salesmen a lesson their successors will not remember.

But the perception of the Fed interest rate-setting being driven in response to equity market distress rather than financial instability or the general outlook is a dangerous one. The timing of the Fed's intra-meeting cut made it look as if the only new information was the global decline in stock markets.

I never believed in the "Greenspan put" (a Fed guarantee against a sharp market decline), but I do believe that image contributed to politicization of Fed scrutiny, the perception that Alan Greenspan's Fed favored capital over labor interests and to an atmosphere less conducive to good financial supervision and regulation.

The recent timing of the response by Ben Bernanke's Fed brings back some of those perceptions and if anything will lead to additional political pressures against reversing and raising interest rates in late 2008 and 2009, when employment is likely to lag behind rising inflation and growth forecasts.

Again, this is an unavoidable cost of pursuing the right policy-a Bank of Japan that worried too much about such perceptions during the late 1990s cost its economy dearly through inaction, even while it established credibility against moral hazard.

There are four steps to mitigate the costs of the Fed aggressively easing, which can begin with the statement from this week's FOMC meeting:

First, restate a de facto target for inflation with an emphasis on the medium term (meaning three years out), including a commitment to bring inflation back down as soon as the current financial risks subside. In short, admit explicitly that the inflation risks are real, but are being put aside temporarily for the greater good, rather than just playing them down or leaving them buried in the "balance of risks" statement.

Second, try to coordinate with other big central banks on forthcoming interest rate cuts (or at least on a common directional bias), as was done on the successful liquidity injections. If what is threatening growth now is the US problem spreading across the world via interlinked financial markets, not just direct demand declines, this is all the more important. Doing so would minimize further dollar weakening and therefore inflationary risks.

Third, accompany these interest rate cuts with tightening of regulations and supervision, to show that this is not about bailouts, but about keeping the financial system functioning fairly. The Fed should also push for continuing rapid write-downs and recapitalizations in the banking sector, diluting current shareholders' value, rather than having banks cut back on lending. When given the opportunity, the Fed should make it clear that day-to-day volatility in equity and real estate markets is not the Fed's concern by allowing some messes to occur.

Fourth, if there is only a limited US slowdown in the first half of 2008, we could well need a "double dip" from a normal Fed induced downturn to stop inflation in mid to late 2009 or 2010. The Fed needs to be out in front with Congress and the next administration preparing officials for this likelihood.

The Fed also needs to make sure its supervision of the banking system today is guided more by prompt corrective action than by regulatory forbearance, to prevent the recurrence of financial disruption from doing the right thing tomorrow.