PR - Euler Hermes Chief Economist: Fed Rate Cut A "Mixed Blessing?

Following the announcement that the Federal Reserve cut a key interest rate by 0.5%, Dan North, the Chief Economist for leading B-to-B accounts receivable insurer Euler Hermes ACI, issued the following economic commentary and analysis:

"We remain on the brink of a recession – if we are not already in a recession – as evidenced by the Q4 GDP report that showed growth of only 0.6%. This number was well below the expectations of 1.2% growth for the quarter, as well as below the long-term average of 3.5%. The three headwinds that have been in place for some time now – energy price spikes, the effects of the Fed’s monetary tightening in 2004-2006, and the burst housing market bubble – have brought about the current economic climate, and the Fed’s response of cutting interest rates is appropriate.

However, while the Fed’s course of action is mostly positive, it is too late to keep the country from sliding into recession since it takes three to five quarters for Fed actions to take full effect.  And the way the Fed has gone about setting policy over the past eight days is a ‘mixed blessing’ at best, for two reasons:

1. The Fed has become overly sensitive to the wants of the global financial markets instead of the needs of the U.S. economy, putting our economy at risk and damaging the Fed’s credibility.
2. The Fed is now setting up unwanted conditions in the future, such as inflation, too much liquidity, and investors seeking way too much risk.

Last week’s action – an emergency 0.75% interest rate cut – was a sharp reaction to a tumble in foreign markets. However, those foreign market conditions may have been exacerbated by the rogue trader for Societe Generale. The fact that the Fed reacted so strongly to actions in markets other than our own that may have been caused by a single trader hurts its credibility. Additionally, the Fed was also backed into a corner today by our own markets, which were clearly expecting today’s 0.5% interest rate cut, and the markets no doubt would have fallen with anything less.  It is clear that this sudden change in policy response – which went from a gradual easing to a more aggressive series of rate cuts – also is hurting the Fed’s credibility.

This policy change now sets up conditions for inflation later – in fact, the CPI was 4.1% for the year, so inflation is certainly not dead. Also, the Fed has created excess liquidity that could easily recreate the conditions that formed the housing market asset bubble.

And finally, the Fed has created a moral hazard – an expectation that the Fed will come to the rescue every time there is significant instability in the financial markets. This will cause investors to think that there will be a ‘Bernanke put’ to save them every time they face serious losses. Investors will then seek too much risk in investments such as subprime mortgages, a condition which could also contribute to the formation of another asset bubble.”

Euler Hermes ACI Chief Economist Dan North uses macroeconomic and quantitative analyses to help develop, price, and manage the company’s risk and insurance portfolio of $150-$200 billion in annual U.S. trade transactions. He holds an MBA from the Wharton School of Business.

Owings Mills, Md.-based Euler Hermes ACI is North America’s oldest and largest provider of trade credit insurance and accounts receivable management solutions and is the US subsidiary of the Euler Hermes Group.