Why the Fed should and should not reduce interest rates

Arguments for:
1. Housing sector in major slump and shows no sign of improving any time soon. Current default woes is raising the bar for borrowers and surely means the economy has yet to see the bottom in the housing market.
2. Liquidity problems in the markets may only be alleviated by major action by the world’s Central Banks and this action must be led by the Fed. If the lowering of the Fed’s discount rate (which has already happened) and the direct flow of liquidity funds from the world’s Central Banks to the marketplace fail to work, then the Fed must take the lead and reduce core interest rates.
3. The US economy is predicted to slow in the second half of the year and an easing of interest rates is the natural course of action to stimulate further economic growth and ensure the economy does not slow too far and slip into a recession.
4. US treasury yields and futures are pricing in a series of interest rate cuts, so the Fed is expected to cut. Markets have priced in a 1% reduction before year end.
5. Negative market sentiment is spilling over to the main street and we are witnessing the first signs of contagion (Ok the evidence is thus far light) – through reduced consumer sentiment, restrictive borrowing and a reported softening in August retail sales.
6. US inflation has been contained for most of this year and is low enough (the core Personal Consumption Gauge is down to an annual 1.9%, with the core CPI rate down to 2.2%) to permit the Fed to reduce rates now.
7. The US economy could quickly drift into recession if something is not done now and the Fed effectively has no choice.

Arguments Against:
1. The problem in financial markets is a liquidity issue and not a wider economic issue. The Fed does not have a mandate to change interest rates purely for providing greater liquidity. The Fed has other tools at its disposal to help with a liquidity problem, something it is currently working at with the markets and major banks.
2. The US economy grew at an annualized 3.6% growth rate in the second quarter. All the evidence thus far for quarter 3 points to further economic expansion, albeit at a slower rate. It would be unprecedented for the Fed to lower the fed funds rate for the purpose of trying to stimulate growth based on current economic data.
3. US inflation has been at or above the Fed’s comfort zone all year and the core consumer price index has been running at a 2.2% rate for the past 3 months, signaling a bottoming out, having come down from a high of 2.9% at the end of 2006. US CPI inflation has not been under the 2% comfort line in over 3 years. With a weak dollar adding to imported inflation, higher energy costs and unemployment at historic lows, there is every reason why inflation should remain at the top of the Fed’s agenda right now and why it would be premature to ease the fed funds rate. In fact inflation in the US is currently higher than that in the euro area and the UK, where the Central Banks remain a firm tightening bias.
4. The current credit crunch has not run for long enough to have had any meaningful deflationary impact on prices so the risks to inflation remain to the upside as per the statement from the August’s FOMC meeting.
5. A reduction in interest rates now would see a rush of liquidity to the market that would have an inflationary impact on consumer prices and could see the Fed having to reverse course and increase rates again early next year. That in essence means it would be a mistake to reduce rates now.
6. Market volatility and uncertainty because of bad debts and risky investments is not the Fed’s problem and is not something that should trigger changes to monetary policy. It is also not the Fed’s responsibility to come in and change monetary policy to help investment companies and speculators that got it wrong.
7. The current downturn in equity markets is a long overdue correction. The apparent credit crunch is a reality check and overall it is good for the economy in the longer run. Monetary Policy intervention is neither required nor justified.
8. With moderate to good growth in the economy and an upside risk to inflation, easing interest rates in this scenario would be akin to pressing a panic button and could have the reverse impact of that desired and plunge the wider economy into major difficulty.
9. The US carries a major current account deficit and relies on foreign purchases of US securities to offset against this deficit. A reduction in US interest rates at a time when rates are rising elsewhere would lead to an erosion of foreign investment, needed by the US to balance its current account.
10. The dollar is already riding near all-time lows and the greenback would probably come under attack if interest rates were reduced. A broadly weakening dollar would lead to higher imported inflation, less appeal for dollar-denominated assets, possible central bank diversification away from US dollars and ultimately reduced purchasing power for US importers and US consumers. This would place the US economy in a much weakened position in the longer run.

By Bob Saint Clair, Ireland.