Voices of Reason Needed in the Current Market Turmoil

As the credit crisis spreads vertically and horizontally across the financial markets, all eyes remain on the Federal Reserve, hoping, just as much as expecting, that interest rates will be cut on September 18. In fact, many are not even questioning whether the interest rates will be cut, but are rather wondering by how much — by a quarter or a half of a percent?

Such sentiment could be translated into a forecast that if the Fed does not reduce the rates, which is also a possibility considering how uncommitted the Fed speeches have been so far, experts are convinced that we should brace ourselves for a sell-off not seen since the 1987 Black Monday. And, as for the few trading sessions left until Tuesday next week, prices are likely to fluctuate within wide swings carried on suspiciously low volumes. Obviously, investors are not venturing into the melee until the Fed sends out a clear signal whether it plans to bail out the financial markets or not.

Yet, in contrast to a growing number of people expecting a bailout from the Fed, there are also other voices, some might label them as voices of reason even, that advocate a different approach. For example, in a speech given at the National Association of Business Economics annual meeting, Janet Yellen, San Francisco Federal Reserve Bank President, said that, “Financial market turmoil seems likely to intensify the downturn in housing; [however] monetary policy should not be used to shield investors from losses.”

Yellen’s argument is simple. She believes the Fed should keep its cool and focus more on keeping inflation under check and the economy at full employment. (Note that “full employment” is a term used in macroeconomics to define the condition in an economy when the real GDP equals the potential GDP, and when aggregate demand is met with aggregate supply.)

Now, this latest downturn in the housing market is very likely going to have an adverse impact on full employment equilibrium in the short-run. The declining consumer spending could hurt the economy if prices of houses keep on decreasing within the context of increasing unemployment. However, longer term, premature overreactions could result in more damage than anything else. Remember what happened after the tech bubble burst in 2000? In response to the stock markets crisis that soon ensued, the Fed cut interest rates as low as one percent in 2003 and kept them at such a low level for a year. This led to something economists refer to as “easy credit,” which resulted in excessive borrowing and getting overly creative with mortgage solutions, finally creating this latest pickle we found ourselves in.

The Fed does not exist to protect investors from stock market losses. It exists to manage inflation, maintain full employment, moderate the business cycle, and contribute to long-term growth of GDP. If the Fed poorly times its monetary policy, the lag effect could be disastrous.

What are we to expect next week from the Fed? A rate cut is more likely than not making any move. By how much? Most likely by 25 basis points. Will it be enough? No. The lending market crisis has not yet fully resolved itself and the stabilization of that segment might require more interest rate cuts. Is there enough information either way for an effective monetary policy? Not yet; this is simply panic talking. Should interest rates be cut in September? Probably not, but I don’t think anyone has the stomach anymore for more sell-offs.