David Prosser's Outlook: The Fed gives in to a stock market panic

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The Independent Online

Wow moments don't come along too often in the world of monetary policy, but the Federal Reserve's emergency 75 basis point interest rate cut yesterday was certainly one of them. To put the Fed's move into context, the last time it cut rates out of the blue, rather than at one of its scheduled monthly meetings, was six days after the terrorist attacks on the United States on 11 September 2001. And even that cut was only 50 basis points. To find the last 0.75 percentage point reduction, you have to go all the way back to August 1982.

US policymakers are fond of the big gesture. This is the financial equivalent of George Bush's famous troop surge in Iraq. Ben Bernanke, the Fed's chairman, is praying that if he throws everything he has at the economic insurgency threatening to plunge the US into recession, he might finally manage to stamp it out.

However, the use of the word wow should not signal admiration. Just as President Bush's change of strategy in Iraq was a clear admission that the American's tactics up until that point had proved disastrous, so Mr Bernanke's dramatic moment yesterday represented a total volte face on his approach to monetary policy since his appointment at the Fed two years ago next month.

Prior to the appointment of Mr Bernanke, previously an eminent academic, he was best-known for his study of the Great Depression, in which he argued that the Federal Reserve was responsible for the economic turmoil of the 1930s because it had failed to respond properly to the stock market crash of 1929.

But until now, Mr Bernanke has been ultra cautious. Sensitive to concerns that he would be seen as too dovish, the Fed under his leadership reacted slowly to the credit crunch, the collapse of the housing market and growing fears of a recession. Mr Bernanke has repeatedly taken a more upbeat line than other economists, including Alan Greenspan, his predecessor at the Fed.

And he spent much of last year resisting calls for significant interest rate cuts, stressing his concerns about inflation and arguing that there were other ways to deal with the credit crisis – the liquidity injections of the autumn, for example.

No one likes admitting they were wrong, but the ham-fisted way in which the Fed unveiled yesterday's rate cut left all concerned looking pretty daft. It said it was taking action in view of the weakening economic outlook and in the face of incoming data suggesting further deterioration.

Pull the other one. No one believes that the Fed, due in any case to meet in eight days' time, has received such worrying information that it had no choice but to cut rates ahead of schedule. This was a panic measure prompted by the global stock market corrections that took place on Monday and again yesterday morning in Asia. Mr Bernanke was terrified by the prospect of a similar sell-off in the US, where the markets were closed on Monday, and announced the rate cuts minutes before trading began.

There's a case to be made for central bankers worrying about stock market downturns. The main source of woe for the US economy right now is a lack of consumer confidence and a collapse in share prices is a surefire way to add to people's anxieties.

However, a policy u-turn of this magnitude, particularly when dressed up as a calm response to deteriorating economic data, won't do much for consumer confidence either. People know what panic looks like and this was it.

Where do we go from here? Well, Mr Bernanke will sit down next week with the Federal Open Market Committee for their scheduled January meeting. By then, they will have spent days listening to demands for a further interest rate cut – anything less than another 50 basis points will be a huge disappointment to the markets.

That's the problem with starting a panic. Whatever you do next is not enough to stem the crowds threatening to crush each other in the rush for the lifeboats. To put it in more sober terms, now that Mr Bernanke has undermined his own credibility, there's no way back for the Fed. Having conceded that it has persistently been behind the curve on responding to the downturn, it's almost impossible to catch up.

Yesterday's shock did at least prevent a bloodbath on the US stock market, boosting the UK in the process. That, however, is a small victory to have won in the much more challenging long-term battle against recession.

As for Mr Bernanke himself, yesterday's loss of nerve spells the end of his chairmanship of the Fed. Whoever wins the US elections this November, don't expect them to award Mr Bernanke a second stint in office when his first term comes to an end in January 2010. He'll almost certainly have time to write another study of central bankers' responses to an impending economic downturn.

Why the Bank dare not follow suit

The US interest rate cut may smack of panic, but there is no shortage of constituencies in the UK that would like to see something similar back home. Estate agents, in particular, were queuing up to complain yesterday that the Fed move proved the Bank of England had made a grave error in keeping interest rates on hold at the Monetary Policy Committee's meeting last week.

Gordon Brown and Alistair Darling are not putting it quite in those terms, but it is clear they have let the Bank know where their feelings lie – that rates should be cut as soon as possible. The CBI's director general, Richard Lambert, yesterday also gently nudged Mervyn King towards a rate cut next month.

There's no doubt Mr King would love to cut rates. Problem is, the Bank's remit is much narrower than that of the Federal Reserve. While his American counterparts are charged with a broad range of responsibilities, including maintaining economic stability and keeping a grip on inflation, Mr King has a specific target: to achieve an inflation rate of 2 per cent.

Last night, the Governor dropped a bombshell – he thinks inflationary pressures in the UK are now so serious that he may be forced this year to write to the Chancellor explaining why the Bank has missed the target by more than 100 basis points. Indeed, the Governor warned he might have to write more than one such letter.

That warning, an even louder note of caution than the alert issued last week by Mr King's deputy, Sir John Gieve, who had a similar message, could hole the case for a series of rate cuts below the waterline. Forget a 75 basis point reduction or even a quarter point – if the Bank thinks inflation is heading somewhere north of 3 per cent, the MPC is heading back towards rate rise territory.

The economic consensus in recent months has been that while the US is moving ever closer to recession, the UK's problems are less serious – a prognosis of slower growth rather than a slide into negative territory. But it is becoming increasingly clear that policymakers here do not have the kind of options the US is currently exploring.

Not only will the Bank find it difficult to cut rates – let alone in the aggressive manner of the Fed – but the UK's public finances are in such a parlous state that the Government cannot afford the kind of fiscal stimulus announced by the US President last week. Tax cuts are certainly not on the agenda any time soon.

Ironically, when Mr Bernanke began his term 18 months or so ago, he hinted strongly that he thought there was a strong case for the Fed to target inflation more specifically. And in the UK, there has been little questioning of the targets handed to the Bank 10 years ago. Now, however, the Bank's limited remit leaves it with a nasty little dilemma. Concentrate on avoiding another embarrassing inflation failure or provide a boost to the economy.

Chances are that the Bank will bite its lip and cut rates next month – it may just have enough room to do so. But don't bank on further reductions any time soon.

d.prosser@independent.co.uk

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