Fed rate cuts went too far

THE Federal Reserve's decision to cut interest rates in response to the US financial market crisis of the past year is a bad mistake that will lead to higher inflation, a former Bank of England official said on Saturday.
In a paper presented at the Federal Reserve's annual conference in Jackson Hole, Wyoming, the London School of Economics professor Willem Buiter, comes down hard on the Fed for misjudging the effects of the US housing market slump.

'The Fed over-reacted to the slowdown in economic activity,' Mr Buiter writes. 'It cut the official policy rate too fast and too far and risked its reputation for being serious about inflation.'

'The official policy rate is a rather ineffective tool for addressing liquidity and solvency issues,' he adds.

As rising default rates on home mortgages and falling house prices in the US housing market impacted the value of financial assets worldwide in the past year, the Fed cut its benchmark borrowing rate down to from 5.25 per cent last summer to the current 2.0 per cent, and has held them steady at the past two policy meetings.

Mr Buiter agrees with the general consensus at the Fed, which is only now beginning to be questioned, that asset price bubbles cannot be adequately dealt with through monetary policy.

However, Mr Buiter writes that proper regulation might have done what the federal funds rate cannot. By sitting idly by while investment banks and hedge funds were taking wild risks in financial markets, the Fed itself holds some responsibility for the developments of the past year, the author argues.

'I do not agree that the best that can be done is for the authorities to clean up the mess after the bubble bursts,' says Mr Buiter.

The European Central Bank and the Bank of England do not entirely escape Buiter's sharp critique. He praises them for resisting pressure to push interest rates lower, but says they too have threatened the independence of central banks by erring on the side of doing too much.

'All three have allowed themselves to be used as quasi-fiscal agents of the state, providing subsidies to banks and other highly leveraged institutions,' Mr Buiter says.

The implications of these actions are far reaching, the author says, and will be felt in the form of inflation pressures that are already showing up prominently in the latest data releases.

US consumer prices jumped 5.6 per cent in the year to July, the highest reading since the early 1990s.

Against that backdrop, the central bank's credibility has already been tarnished, according to Mr Buiter.

'The Fed's reputation for maintaining price stability has been severely dented,' he said in an e-mail interview.

Another key error on the central bank's part was to overestimate the role of falling prices on overall economic activity, and to give too much credit to the productive use of purely financial businesses.

'Much of it is privately profitable but socially wasteful churning, driven by regulatory arbitrage and tax efficiency considerations,' concludes Mr Buiter.