Fed Looks, Stays Calm, Does Only What's Needed: John M. Berry

-- Federal Reserve officials yesterday gave investors and traders much less than they wanted.

The Federal Open Market Committee cut its target for the overnight lending rate a quarter-percentage point, to 4.25 percent. It didn't go a half point, as many analysts had urged, and it didn't say in its statement that the risk to growth outweighs the risk of more inflation.

Nor did the Board take any new steps to entice banks to borrow directly from the Fed to ease the worldwide squeeze on liquidity, a possibility widely discussed in the markets.

Stock prices plunged on the news, and so did yields on Treasury securities, presumably on the assumption that the lack of more vigorous action by the Fed means the economy will continue to weaken and eventually require several more rate cuts.

That reaction couldn't have surprised the policy makers. The fact that they didn't do more only underscores the differences between how most Fed officials and most analysts and investors view the economic outlook.

Stubbornly, Chairman Ben S. Bernanke and most of his colleagues insist on keeping one eye on inflation while sticking with their collective forecasts that after a weak fourth quarter economic growth will gradually pick up in 2008.

As for the balance of risks, the committee didn't assess them. Instead, it said only that recent developments ``have increased the uncertainty surrounding the outlook for economic growth and inflation.''

Leaving Door Open

``The FOMC appears to be leaving the door open to further action, but is stopping well short of guaranteeing such moves,'' economist David Greenlaw of Morgan Stanley said after yesterday's move. ``Clearly, the Fed's assessment of economic outlook is not as dire as implied by our own forecast.''

Investor expectations for a revamping of the discount rate, traditionally the rate the Fed charged as lender of last resort, were misplaced.

It's not the 50-basis-point spread between the overnight rate target and the discount rate -- which was also lowered yesterday by a quarter point, to 4.75 percent -- that makes banks reluctant to borrow from the Fed. After all, on Dec. 10, the London Interbank Offered Rate, or Libor, for one-month money was 23 basis points higher than the Fed's discount rate.

In recent years, the Fed has tried repeatedly and unsuccessfully to persuade banks to borrow to relieve liquidity pressures. The problem is, as a former Fed official put it, ``the banks that most need to borrow are the most reluctant to do so because everyone will then think they are in serious trouble.''

Reduced Lending

It was unexpected tightening of conditions in the interbank lending market that began around Nov. 20 that led to yesterday's cut. Bernanke and Fed Vice Chairman Donald L. Kohn said in speeches late last month that problems in that market might cause banks to reduce lending to businesses and consumers, hurting economic growth.

Yesterday's FOMC statement noted that ``strains in financial markets have increased in recent weeks,'' and it also cited worsened conditions in housing and ``some softening in business and consumer spending'' as reasons for lowering the lending rate target.

In a Dec. 3 speech, Janet L. Yellen cited those same reasons for why she has lowered her forecast for coming quarters. However, the change wasn't all that great, she said.

She said she expected the economy to resume growing at about a 2.5 percent rate in a year or so, with unemployment ``rising only gradually to just above its 4.75 percent sustainable level.''

The Dissenter

That's the sort of thinking behind yesterday's decision that analysts have to understand. Given the delays with which monetary policy affects the economy, officials are reacting not directly to recent events, but to how those events affect their forecasts.

Eric S. Rosengren, Yellen's counterpart at the Boston Fed, had a dimmer view of the outlook and dissented yesterday in favor of a half-point cut.

In a Nov. 26 interview, Gary Stern, president of the Minneapolis Fed, said investor expectations for Fed policy are ``a factor'' in FOMC decisions.

``If we surprise the markets, we may get a big market reaction for a day or two,'' he said. ``But if it's right on the fundamentals, it should work its way out. And if we make a mistake, we can correct it.''

After the FOMC reduced the lending rate target by a quarter- point on Oct. 31, none of the officials was thinking about a rate cut at yesterday's meeting. They executed one because circumstances changed.

It's clear from yesterday's statement that they have no clear expectation of what they will do at the next meeting on Jan. 29-30.