The coverage of the Fed's half point cut in interest rates yesterday highlighted the enthusiastic response of the markets. According to much of the coverage, the markets soared yesterday because they are now confident that Bernanke will move aggressively to try to counteract a recession. A bit of history would have been useful to include in this context. As some articles noted, this cut bears a resemblance to the Fed's 0.5 percentage point cut in January of 2001 at an unscheduled emergency meeting. That cut also led to a very enthusiastic response from Wall Street. The Dow rose 2.8 percent following that cut and the Nasdaq jumped by a record 14.2 percent. In reporting on the significance of the cut, the NYT quoted Bruce Steinberg, chief economist at Merrill Lynch: "there's a simple message, the Fed will do whatever it takes to keep the U.S. economy from going down the tubes.'' Mr. Steinberg may have been right about the Fed's intentions. It did continue to cut interest rates, lowering the federal funds rate by a total of 5.5 percentage points to 1.0 percent, the lowest rate since the mid-fifties. However, this rate cutting did not prevent the economy from falling into a recession. It began to lose jobs just a month after the January rate cut. In spite of the Fed's aggresive rate cutting,the economy remained so weak that it took four full years to once again reach the employment levels of February 2001. The lesson from the 2001 experience is that cutting interest rates is not necessarily a very effective tool in counteracting the impact of a collapsing asset bubble. My guess is that rate cuts will provide even less effective stimulus now than they did in 2001, primarily because they will not reverse the decline in house prices and the wave of defaults and foreclosures that will follow. In any case, it would have been helpful to note the failure of the Fed's last effort to prevent a collapsing asset bubble from causing a recession in discussions of the impact of this latest rate cut.
--Dean Baker
