In every Federal Reserve policy cycle there comes a crucial time when policymakers have to decide when enough is enough. Right now, the timing for a pause in the Fed's rate cutting feels right: Its quarter-point cut on Apr. 30, to 2%, lowered the target rate to a level historically associated with very stimulative financial conditions, and its patchwork of lending facilities has shown some success in calming the credit markets. Recent data—including a small plus for first-quarter economic growth—do not suggest a severe recession, while stubborn inflation is an argument against further stimulation, especially with Washington's rebate checks on the way.
A pause right now, however, is an especially high-risk decision. The credit crunch changes the calculus of effective policymaking, even as it increases the uncertainty in the economic outlook. Despite the Fed's massive rate cuts, it's difficult to know just how much of that stimulus will find its way into the economy, compared with past business cycles. And financial conditions, while improved in recent weeks, remain uneven. So it's far from clear whether the Fed has done too little or, as some policymakers fear, too much.
Taken at face value, Fed policy is now highly stimulative. By any metric, the inflation-adjusted target rate is now negative for the first time since the Fed's sharp policy easing during and after the 2001 recession. It's far below the 2.4% historical average thought to be consistent with a neutral policy, one that neither stimulates nor constricts economic growth.
However, the impact of financial conditions depends on many other factors, including market rates across all maturities, the level of risk embodied in those rates, the willingness of banks to lend, stock prices, and the dollar's value. Clearly the cheap dollar is stimulative, as it boosts exports, limits imports, and attracts foreign investment. Other conditions are still restrictive. Credit spreads between market rates and riskless Treasury securities have narrowed, but these risk measures remain far wider than historic norms. Big banks are more focused on their balance sheets than on making loans, and all banks have tightened their lending standards.
Sharply tighter mortgage lending standards, combined with the ongoing stress in the secondary mortgage markets, are perhaps the biggest reasons why the Fed's easing to date is not having its usual effect. A full recovery in the economy depends, crucially, on a turnaround in housing, but housing's recovery depends on the mortgage market. One danger is that home prices continue to plummet, generating a new round of mortgage-related stress in the credit markets. Through February, the drop in the Standard & Poor's Case-Shiller 20-city home price index continued to accelerate, with prices down 12.7% from a year ago.
Despite these uncertainties, the Fed's Apr. 30 statement suggests policymakers are a tad less worried about economic growth while still concerned about inflation. The report on first-quarter real gross domestic product supports that view. The 0.6% growth rate, the same as in the fourth quarter, means the economy has yet to post even one quarter of negative growth, although the details of the report looked much weaker. In the second quarter, tax rebates, which are hitting bank accounts earlier than expected, will put a cushion under consumer spending. The rebate effect will be temporary, though, which means it's unlikely to encourage businesses to hire and expand.
The Fed is banking on the longer-lasting effect of its rate cuts, some 70% of which came in the first four months of this year. Given the typical lag between policy easing and its economic impact, the full effect of those reductions won't arrive until summer at the earliest. Until then, policymakers will be on the sidelines with their fingers crossed, hoping the credit markets don't suffer a setback. That could raise the need for additional cuts, even as inflation worries persist.