One of the top monetary economists in the nation is seemingly bent on being a Fed apologist. Over at the WSJ Real Time Ecomics blog, Mark Gertler is defending the Fed's surprise interest cut last Tuesday. This is too bad, but not altogether surprising given his defense of the Fed's extremely loose monetary policy during the 2003-2005 period. Here is what he says regarding Tuesday's rate cut:
"... plans for significant easing was in the works before Tuesday. The global asset price decline certainly influenced the timing of the cuts, but I don’t believe it’s going to affect the medium term path of the Funds rate, which is going to be governed by events in the real economy."
So he admits global asset prices influenced the timing of the decision to cut rates. Does he not find this troubling? Since when is it in the Fed's mandate to respond to stock market movements? The only way to wiggle through that question is to reply (a) the stock market is harbinger of things to come in the real economy or (b) that the stock market decline itself will create real economic problems. He opts for the later:
"... [G]iven the weakened state of financial institutions, a sharp asset price contraction had the potential to significantly disrupt credit flows and thus do significant harm to the real economy. The Fed action offset this potentially disruptive chain of events."
Even if he is correct in this assessment, I see several new problems the Fed has created by this action. First, it sets a precedent for a 'Bernanke Put', similar to the 'Greenspan Put'. The market now knows that in the mind of the Fed it is too important to fail because of the potential real economic harm it may cause. Second, although Mark Gertler says the 'medium term path' of the fed funds rate has not changed because of this move I am less certain. The Fed's move last Tuesday set in play a whole new dynamic, as market expectations have now changed. How can Mark be so confident the 'medium term path' will now be the same? This is not a static world. Third, the Fed just used up a large chunk of their valuable ammunition on an uncertain outcome. Given the liquidity trap rumblings we now hear, this rate cut may be costly down the road. I may be wrong in my assessment, but for now the rate cut still appears to me as a panicked Fed responding to market volatility.