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December 5, 2007

Doing What You are Expected to Do

Brad DeLong comments on current Fed policy:

Notes on the Federal Reserve's Current Actions, by  Brad DeLong: The Federal Reserve is now focusing on what Larry Meyer calls "liquidity tools" to make sure the market for short-term credit functions despite concerns about counterparty risk and collateral values. The Federal Reserve hopes that it can handle the current situation without having to ease monetary policy--that its liquidity tools will do enough, and that it won't feel forced to rescue market liquidity by cutting interest rates and thus giving what it fears would be an unhealthy boost to spending. (I think the Federal Reserve is wrong here: the fallout from the current liquidity panic means that a year from now we are likely to wish that the Federal Reserve had given a boost to spending today.)

The New York Federal Reserve Bank has not pegged the average funds rate to its 5.25% target, and it now says that it wants to see "trading in the federal funds market at rates close" to 5.25%, not at 5.25%, and the rate has not been at the target for a week. Nevertheless, the target rate has not changed.

My view is that the FOMC is likely to cut the federal funds rate by 25 basis points at its September meeting, but it will do so reluctantly, because markets expect it, not because it believes the situation warrants it.

Of course, if the financial panic-in-embryo starts to affect spending and to slow the real economy, the FOMC will start cutting rates much further and faster.

Brad mentions something I've been wondering and meaning to bring up here. Would/could the Fed set the target rate at a level different from what markets expect? Certainly if there is a split in expectations, say 50% expect the Fed to hold at 5.25% and 50% expect the Fed to cut the target rate to 5.00%, they would have to go one way or the other, but suppose it is 95% for a rate cut, 5% to hold. Does the Fed currently have the courage and credibility to deviate from what it is expected to do by the vast majority of market participants? Brad says no - it will do what the markets expect, even if it thinks the move is not warranted.

That's my sense too and, if that is correct, policy right now is mainly about managing expectations since that determines the rate that will prevail. Maybe I'm wrong - perhaps he Fed would do what it thinks is best whether or not markets expect it - but I think they are largely bound by prevailing market opinion.

Ben Bernanke is still being tested, still establishing his credibility. If he deviates from expectations and turns out to be wrong, then his choice will be questioned - why didn't he listen to the markets? - and the credibility loss could be large (just an academic book guy, not like dear old Alan...). Of course, if he deviates from expectations and is correct he would be hailed, but it is a risky strategy to deviate from expectations at this point.

If the Fed is successful at managing expectations, we'll never know about this since they would always do as expected, and I've assumed the Fed is fairly united itself in what ought to happen (they could be split as well and deliver mixed signals), but I think there is a good chance they will face this choice soon and, if they cannot shift market expectations prior to the meeting, will give in to market opinion. I'm not 100% positive about that, but I do think maintaining credibility going forward - as much as possible - is a substantial constraint on their choices.

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