The Fed lowered its target for short-term interest rates by 0.5 percentage point to 3% yesterday, and left the door open to further cuts. The reason for this move is not rooted in favorable inflation outlooks. Indeed, the FOMC statement concludes "that inflation [will] moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully". The Committee rather sees further downside risks to economic growth which endorse a fed funds cut.
Well, I just don't get it what the guys at the FOMC are doing. Financial markets only expected a 25 points decline. This is what markets wanted (and needed). I identified the following points which might help to explain the recent move.
Firstly, helicopter Ben tries to move markets and to elude market expectations. Especially in academics, this issue is hotly debated to what extend a central bank has to serve as a market mover and not just as an executer of current market needs. However, this point is somehow weak. The FOMC would be well advised not to play against its objectives with the sole aim of showing activism.
Secondly, Ben gave up his academic research agenda and changed his opinion when it comes to the question of reacting to asset price misalignments. A huge body of work by the FED's chairman concentrated on the discussion whether it could be useful to directly respond to asset-price dynamics. Among others, Bernanke argued that it would be not favorable to directly follow an asset-price target or to respond to non-fundamental movements. Asset prices become relevant only to the extent they may signal potential inflationary or deflationary forces. Well, then the question is whether the recent stock market crash may indicate deflationary forces. In my opinion, definitely not! Since the start of the re-easening cycle of the FED we can observe a jump in inflation expectations measured as the difference of inflation-protected bonds and treasuries. Consequently, this argument cannot hold. In addition, many proponents of the Inflation Targeting approach such as FED Richmond's economist Marvin Goodfriend comments that even an inflation targeting strategy would not allow for any rate cuts. Why? Pretty easy, since there are no signs of deflation or disinflationary phenomena. Indeed, the analysis of many variables indicates that there is rather inflationary pressure. In addition, the argument of many market commentators that the FED knows more about the economy and potential downward risks can be ironically denied by recent research by FED staff itself. According to John Faust of John Hopkins University, "no model we assess [at the FED], however, including Greenbook, historically outperforms a naïve forecast based only on the best available estimate of recent GDP itself."
To sum up, to me recent FED policy is highly discretionary with changing weights for the benefit of the output objective and at the cost of the inflation objective. I don’t know any reason why the FED changed preferences. Hold on (I'm Coming), one argument could be that even so-called academics may become politicians! And we know what politicians seek for – to be elected or to help other to do so. I know it is an old argument but ex post it was often proved to be right! Another way at looking at the obvious preference change would (also) come from a political motivation; this time, however, with the economic rational of inflating the massive U.S. debt away. If this is the real intention of Bernanke and the U.S. government in general, we all know what will happen: the collapse of the U.S. credit market definitely will spill over and trigger a word-wide financial crisis which we experienced several times in history (with both depression in the 30s and recession at the end of the 60s).
