Feds Get Your Attention

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The Fed tries to get your attention

Prepared by Alex Carrick, Chief Economist, CanaData

On January 22 2008, the U.S. Federal Reserve Board dropped its key policy-setting interest rate by 0.75 percentage points. The federal funds rate now stands at 3.50%, down from a high of 5.25% in much of 2006 and early 2007.

The Fed’s rate cut was dramatic in two ways – (1) its timing, arising out of a special meeting only one week in advance of a regularly scheduled session; and (2) the degree, much bigger than most outside estimates had been expecting.

The Implications are Clear

The implications are clear. The Fed is concerned about the U.S. slipping into recession. The problems stemming from the subprime mortgage crisis late last summer have spread over into housing prices, availability of funds and the stock market. On Monday, January 21, while markets were closed in the United States for a holiday, equities in other markets around the world had their largest price drops since 9/11. The Fed is trying to nip this economic downturn or recession in the bud.

The immediate effect of the rate cut will be more incentive for consumer spending. It will also give at least a temporary respite to the concerns of stock traders. Also, by providing easier access to funds, it will provide stimulus for businesses to invest in machinery, equipment and structures. The good times for non-residential construction will be prolonged and the floor in new housing markets may be reached earlier.

Long-term Consequences Harder to Read

The longer-term consequences are harder to determine. Year-over-year price inflation at 2.4% for the “core” rate and 4.1% for “all items” is barely under control. Also, lower U.S. interest rates may result in more downward pressure on the U.S. dollar. At some future date, these factors may well combine to force U.S. interest rates back up again sooner and higher than might otherwise be needed. For the moment, however, the Fed is apparently content to go with the notion that a stonger U.S. economy will correct most fault lines in the economy.