Fed slashes rates as US growth weakens

US fourth quarter GDP growth turned out even weaker than many had expected. MarketWatch reports:

The U.S. economy barely grew in the fourth quarter, pulled down by a worsening slump in housing and heightened caution by consumers and businesses, the Commerce Department reported Wednesday.

The 0.6% annualized growth rate in gross domestic product was lower than the 1.1% expected by economists surveyed by MarketWatch. The drag from inventories was larger than expected.

Despite the slowdown, inflation persisted.

Even as growth slowed, core inflation heated up, the government said. The core personal consumption price index rose at a 2.7% annual rate in the quarter, far above the Fed's goal of 1% to 2% and the fastest pace of inflation seen in six quarters.

Meanwhile, the labour market may be holding up better than many expected. Yesterday, the ADP employment report showed that the private sector added 130,000 jobs in January.

However, the Federal Reserve appears to be focused on the negatives. MarketWatch reports the latest FOMC decision.

Fearing that financial-market turmoil and a weak housing market could cause the economy to spiral downward, the Federal Reserve moved aggressively for the second time in eight days to lower interest rates and signaled it was ready to do more as needed.

The central bank lowered the federal funds rate by 50 basis points to 3%. Financial markets were hoping that the Fed would decide to cut rates by this amount. The Fed has cut rates by 1.25 percentage points in eight days, almost unheard of in central banking history.

US stocks initially rallied after the rate announcement, but the rally didn't last long. MarketWatch reports:

U.S. stocks crumbled into the close on Wednesday, after earlier rallying in reaction to the Federal Reserve's much-anticipated half-point rate cut, with speculation that bond insurers Ambac Financial and MBIA Inc. faced downgrades helping to fuel the late-session losses...

Down about 30 points ahead of the Fed decision, the Dow Jones Industrial Average rallied nearly 200 points before retrenching as the closing bell neared to finish 37.5 points lower to 12,442.8.

And, perhaps significantly, while yields on Treasuries generally fell yesterday, those on long-term bonds did not. From Reuters:

Short-dated U.S. Treasury debt prices rallied on Wednesday in the wake of an aggressive half-percentage-point rate cut from the Federal Reserve and safe-haven flows out of the falling stock market...

But the 30-year long bond suffered. Though they would be expected to underperform during a period of deep rate cuts, analysts said the price action also reflected inflation worries.

Long bonds dropped 16/32 in price on the day to yield 4.39 percent. Prices on the long bond were earlier down more than a full point.

Even Bill Gross has doubts about the efficacy of rate cuts.

Approaches to monetary policy must change... 1% short rates were so effective 5 years ago that they not only bolstered demand but created a housing bubble of Frankensteinian proportions. Those days, however were influenced by the creation and implementation of adjustable-rate mortgages (ARMs) that were priced at the short end of the yield curve... But adjustable-rate mortgages are a dying relic. Originators will no longer offer them except on onerous terms.

And so the monetary attempt to halt housing’s – and therefore the economy’s – downward slide rests on the shoulders of the 30-year mortgage...

My point is that Chairman Bernanke must recognize the reduced benefits and obvious dangers of a déjà vu trek to 1% short rates. Those yields produced 5% 30-year mortgage rates to the homeowner for a 2-3 month period in 2003 and they could do so again, but bubble creating, inflation inducing damage to the U.S. dollar would be the likely result now. Best to stop far short of 1% and at the same time encourage reforms in FHA government assisted programs that would permit subsidized mortgage rates with minimal down payments.

And if the point is still not taken, maybe invoking fears of the 1930s would help.

... As Keynes theorized and then Krugman affirmed, when private demand falters, it becomes the responsibility of government to fill the breach. Because it likely will not do so effectively until after a new Administration is elected in late 2008, the U.S. economy and its somewhat coupled global companion will sleep walk for some time and a resumption of prosperity as we knew it will be dependent on reforms of monetary and fiscal policy resembling the 1930s more than our past decade...