Investor's Business Daily, September 17th, 2007
Economy: What the Fed does Tuesday will set the tone not just for the rest of the year, but for the rest of the decade. With so much at stake, the central bank has to get it right. That means a bigger rate cut than expected.
In this case, the right thing would be to drop the fed funds rate at least a half-point 15 4.75%. This would help keep the credit crunch from morphing into an ugly recession -- something the Fed can avoid if it acts quickly and boldly to re-liquefy the economy.
A little over two weeks ago, Fed Chairman Ben Bernanke said these words: "Well-functioning markets are essential for a prosperous economy." Fed policies, he added, will try "to promote general financial stability and to help ensure that financial markets function in an orderly manner."
All well and good. But despite a 50-basis-point cut in the seldom used discount rate, the markets have been anything but "orderly." Or "stable," for that matter.
Nor is it clear we've dodged a bullet when it comes to recession. As noted here recently, the tone of many market participants has gotten gloomier -- a sign of growing fear the economy is sliding into recession.
There's a whiff of desperation in the air. This could be seen over the weekend, when Hovnanian Enterprises slashed the prices by 20% or more on homes it has built in 19 states. Along with August's loss of 4,000 nonfarm payroll jobs -- the first such decline in half a decade -- and the economy has started to look shaky.
As our friend Larry Kudlow puts it, we now live in "a 2% economy" -- that is, an economy where trend growth is 2%. We agree with him -- not bad, given all that's happening.
But for four years we lived in a 3% economy -- roughly equal to our 2%-plus productivity growth plus 1% growth in the workforce. That's the trend. So falling to 2% growth or lower isn't acceptable.
Why the sudden weakness? Thanks to housing's decline, lenders have become risk averse. Even good credit risks have to borrow in the short-term commercial paper market -- maturing in less than a week -- to finance their businesses. No company can thrive on such a short financing cycle -- much less grow or build its assets.
Yet, as economist Ed Yardeni notes, such desperation borrowing exploded in the most recent week from $265 billion to $503 billion.
Plainly, the Fed has fallen behind the curve, a fact Bernanke acknowledged Aug. 31 when he said "global financial losses have far exceeded even the most pessimistic projections of credit losses on those loans." Translation: "It's worse than you think."
The danger for the Fed is that the tail now seems to be wagging the dog. The 10-year Treasury note yields around 4.45%, more than 75 basis points below the fed funds rate. This inversion shows that credit conditions are abnormally tight -- a big reason companies and homeowners can't get financing.
The market seems evenly split on what the Fed will do. Our hope, and advice, is to cut by 50 basis points at least. That would get the central bank back on top of things and give it some policy traction.
Those worried about inflation should check the most recent data. The core personal consumption deflator -- the Fed's preferred inflation target -- is below the 2% ceiling that policymakers have imposed.
Clearly, what's needed now is a bold strike against recession, not some rear-guard action against a vanquished foe.
