2007 Business Review — Federal Reserve

The Federal Reserve acted strangely in 2007. Some might argue precipitously or perhaps even recklessly.

In the wake of a two-year period in which the Fed raised short-term rates too far, too fast, the Central Bank this year sprinted in the opposite direction.

On Tuesday the Fed cut the fed funds rate 1/4 point. That follows a 1/4 point drop at its prior meeting and a sizeable 1/2 point drop the meeting beforehand. The fed funds rate is the interest rate banks charge each other for overnight loans. A few months ago the Fed took the highly-unusual step of cutting its discount rate; on Tuesday the Fed repeated itself on that front. The discount rate is the interest rate the Fed charges banks for direct loans from the gov’t.

The end result of all this action, predictably, is that the Fed has painted itself into a corner.

If inflation were to spike Bernanke & Co. would face a Hobson’s choice: slowing the economy down to a crawl with renewed rate hikes or slowing the economy down on the reverse side by not responding to price pressures. The Fed also set the dangerous precedent of having given the *appearance* of being swayed by Wall St. traders and by negative headlines from the Pravda-esque media.

Fortunately, however, worker productivity remains at such high levels that a spike in inflation is very unlikely. The economy should be able to absorb without too much difficulty not only the 2004-2006 rate hikes but also the massive doses of liquidity in 2007. In other words it looks as though the Fed will succeed in its mission — somewhat if not mostly in spite of itself.

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