Grown-Ups Take Charge At The Fed

Economy: Why did the stock market rally furiously after a top Fed official spoke Wednesday about the challenges the U.S. economy faces? Could it be the markets finally think the Fed gets it — and that adults are in charge?

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It was interesting to see how just a few words from Donald Kohn, vice chairman of the Federal Open Market Committee, had such a big impact on market sentiment.

Within minutes of his early morning speech to the Council on Foreign Relations, markets took off. By day's end, the Dow industrials had surged 2.6% and the Nasdaq 3.2%.

What did he say?

That the Fed will "act as needed" to shore up the economy. That the nation's central bank would stay "flexible and pragmatic" in dealing with the housing crisis and credit crunch, which are showing signs of weakening the economy.

More importantly, Kohn suggested the Fed wouldn't let fear of "moral hazard" — bailing out banks and investors after they've made bad bets — deter policymakers from doing the right thing.

Music to the market's ears. Because in recent weeks, some relatively inexperienced Fed policymakers have made noises about letting the crisis play out without the Fed doing much more to stop it. These officials also seemed to suggest inflation, not recession, was tops on their list of concerns — something starkly at odds with market thinking now (see chart).

No doubt about it — recent data have turned quite sour. Just Wednesday, the government reported that nondefense capital goods, excluding aircraft — a key piece of data used to calculate GDP — plunged 1.2% in October.

Meanwhile, existing-home sales in October fell by 1.2%. The 6.3% annual drop in single-family home prices was the biggest ever.

Then there was the Fed's own survey of economic conditions, also released Wednesday, which showed the U.S. economy continuing to grow during the survey period of October to mid-November, but at a "reduced pace." Of 12 Fed regions, seven reported slowing.

In just the past month, yields on 10-year Treasury notes have plummeted nearly 70 basis points to about 4%. That means the yield curve is inverted, signaling either a major slowdown or a recession. It also means markets aren't fearing inflation, at least not now.

Concerns of moral hazard aside, it's the Fed's job to keep the banking system's serious ills from becoming systemic — that is, from infecting the economy and causing a recession. Worrying about wasting water when the house is burning isn't wise.

As Kohn aptly put it, "We should not hold the economy hostage to teach a small segment of the population a lesson."

That suggests Kohn will support another quarter-point rate cut when the Fed meets Dec. 11. That would push the benchmark funds rate to 4.25%, the lowest since late 2005.

Kohn's remarks were, in the words of the New York Times, "strongly worded." That was no accident.

A quick breeze through Kohn's resume suggests he understands quite well the balancing act the Fed must perform between controlling inflation on one hand, and keeping the economy growing and the banking system whole on the other.

Kohn probably has more real experience as a central banker than anyone at the Fed, having started his career there as a staff economist in 1970 and working there pretty much ever since.

He understands inflation is a danger. But he also understands that banking crises — such as those in the late 1970s and early 1980s, again in the early 1990s, and yet again in 1997 and 1998 — can have far-reaching impacts on the economy.

Better to cut rates now, let banks shore up their balance sheets and start lending again than to let it all unravel and push the U.S. into an unnecessary recession. That's what Kohn seems to be saying. Let's hope the Fed's less-experienced hands are paying attention.