Are they going too far?

In an effort to "forestall some of the adverse effects on the broader economy that might otherwise arise" from the summer credit crunch, the Federal Reserve cut its target for short-term interest rates a quarter of a percentage point to 4.5% yesterday. This action comes six weeks after the Fed’s ½ point cut in September.

While the cut was anticipated, the accompanying statement was a bit more surprising. In an apparent attempt to rein in market expectations of further action, the statement noted that the Fed now sees the risks of weaker growth and higher inflation as "roughly [in] balance." Almost immediately, stocks and bonds sold off, as investors pondered the idea that perhaps Ben Bernanke’s Fed would not serve up a series of reflationary rate cuts. But then cooler heads prevailed and stocks closed on the highs of the session. It is Bernanke, after all, and the housing market is in the can, so that statement seemed more like a warning with a wink: “don’t count on us, but don’t worry, we’ll be there for you.”

The more interesting action was taking place in the commodities pits, where crude oil touched a record-high $94.74 after an Energy Department report showed that U.S. inventories fell to a two-year low. Dec crude finished the day up $4.15 or 4.6% at $94.53, which makes October’s gain a staggering 16%! For those history buffs, we have just over $7 before we reach the April, 1980, inflation-adjusted record of $101.70. Additionally, Dec gold added $7.50 to $795.30.

After examining those results, one might take away a bit of concern over inflation gurgling up. Before we get into one of those nutty arguments about how inflation is measured, let’s agree that the CPI is not perfect. That said, although raw materials prices have been on the move for five years or so, we have not experienced a huge impact on finished goods prices—that’s one of the many wonders of globalization. It would take far more price-push for core inflation to become a problem. Indeed, the CPI has been coming down from its cycle high 4.7% in September 2005 to the recent approximate 2% level.

As I noted yesterday, weaker US growth caused by a continued housing recession should increase economic slack and thus compress pricing power even further. This effect should translate into low core inflation, which is why I don’t think that the Fed has gone too far—at least not yet!