The Fed's pre-emptive moves

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Less than six hours after the Commerce Department reported yesterday that the economy had sputtered with an unexpectedly slow annual rate of 0.6 percent during the fourth quarter, the Federal Reserve announced that it had reduced its short-term target interest rate by a half-percentage point. Combined with the extraordinary three-quarters of a point reduction announced eight days earlier after an emergency meeting and three previous cuts since mid-September, the Fed has now reduced the federal-funds rate by 2.25 percentage points to 3 percent.

The last time the fed-funds rate reached 3 percent during a rate-cutting cycle occurred six days after the September 11 terrorist attacks, which took place during a recession. Eventually, the Fed lowered its target rate to 1 percent in mid-2003 and kept it there for a year before methodically raising it a quarter-percentage point every six weeks or so until it reached a relatively low cyclical peak of 5.25 percent in June 2006. In September 1992 (18 months after a recession had ended), the Fed also lowered its target interest rate to 3 percent — and that was the lowest it went during that cycle.

Thus, with the economy still showing positive, albeit minuscule growth during the fourth quarter, the Fed is clearly acting in an aggressively pre-emptive fashion.

The central bank thinks it has good reasons for doing so, despite a major acceleration in inflation. In yesterday's press release, the Fed acknowledged that "[f]inancial markets remain under considerable stress," a condition that first manifested itself in August, abated somewhat in September and October and then returned with a vengeance in November. The Fed also noted that "recent information indicates a deepening of the housing contraction." That's an extreme understatement. After declining 12.8 percent during 2006, residential investment (the construction of new housing) plunged another 18.3 percent during 2007. Meanwhile, new-homes sales in December were 41 percent below their year-earlier level, while the median new-home price fell 10 percent over the same period. The latest S&P/Case-Shiller index, which measures the changes in existing-home prices in 10 major metropolitan areas, revealed that house prices have declined 8.4 percent during the latest 12 months, a record-breaking descent. And home-foreclosure filings surged 75 percent in 2007.

Even though its latest (October) published economic forecast projected that the economy should grow between 1.8 percent and 2.5 percent this year, the Fed revealed yesterday that "downside risks to growth remain." There's not much breathing space between the fourth-quarter growth rate of 0.6 percent and an outright recession. The Fed also said it "expects inflation to moderate in coming quarters."

It had better slow down because, for the record, consumer price inflation accelerated from 2.5 percent during 2006 to 4.1 percent during 2007 (the fastest pace since 1990), and producer price inflation exploded from 1.1 percent during 2006 to 6.3 percent during 2007 (its fastest rate since 1981).