The Fed plays follow the leader

Some critics argue the Fed is too worried about market woes; others say central bank can't buck investor expectation by leaving rates unchanged.

NEW YORK (CNNMoney.com) -- Economist Milton Friedman once famously claimed a computer could handle the rate-setting duties of a central bank. In the last month it has appeared to many critics that the financial markets have taken on that role.

The Federal Reserve slashed rates by three-quarters of a percentage point, or 75 basis points, on Tuesday, just eight days ahead of its regularly scheduled meeting, suggesting that it was responding to problems that couldn't wait.

But those immediate concerns were apparently found in the financial markets more than in the economy, which is the normal focus of the Fed's attention.

"While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households," said the Fed's statement that accompanied its surprise move, an unusual acknowledgement that the policymakers were following the markets' declines.

Now investors who a week ago were expecting only 75 basis points of cuts by the end of this month are expecting additional cuts at Wednesday's meeting. Fed funds futures on the Chicago Board of Trade are pricing in a 100 percent chance of a quarter-point, or 25 basis point cut, and a 66 percent chance of a half-point, or 50 basis point cut, on top of the emergency move.
The dark side of interest rate cuts

And some Fed watchers say if the Fed delivers a cut, it'll be a sign that Chairman Ben Bernanke and the rest of the Open Market Committee are being bullied by the markets.

"The action this week raises more questions than it answered," said Barry Ritholtz, CEO of Fusion IQ, a quantitative research firm. "The Fed's mandate is to maintain price stability and promote economic growth, not backstop the equity markets. That's not their responsibility, but it seems to be what they're doing."

Setting the stage for "substantive" move. Bernanke had signaled the Fed's willingness to make additional cuts in a Jan. 10 speech, in which he promised the Fed was "ready to take substantive additional action as needed to support growth."

But while those comments got a lot of attention, there was far less attention paid to his comments that tied problems in financial markets to the Fed's broader goals of economic growth.

"Adverse economic or financial news has the potential to increase financial strains and to lead to further constraints on the supply of credit to households and businesses," he said.

The next day, Fed Gov. Frederick Mishkin, a close ally of Bernanke who had written an economic textbook with him before either joined the Fed, gave a speech in which he argued that the Fed needed to be prepared to respond quickly to changes in financial markets.

"Timely action is crucial when an episode of financial instability becomes sufficiently severe to threaten the core macroeconomic objectives of the central bank," he said.

Those comments raised hopes that the Fed would cut rates ahead of the two-day meeting on Jan. 29 and 30. But some of those hopes started to retreat when there was no cut by Friday Jan. 18, as many Fed watchers assumed there would be no emergency move the week before a regularly scheduled meeting.

"Suckered'" by SocGen But the following Monday, as U.S. markets were closed for the Martin Luther King, Jr. holiday, most major markets around the globe saw a sharp sell-off.

By late Monday, as futures were suggesting the Dow could open hundreds of points lower the next morning, Bernanke called an emergency meeting to get agreement on the cut that would be announced the next morning, the steepest cut since 1984 and the first emergency Fed move since it cut rates a week after the Sept. 11 terrorist attack.

Still, while markets seemed to get some support from the cut, there was growing criticism from many economists that the Fed was overreacting to the markets.

That criticism became even louder Thursday when it was revealed that French bank Societe Generale (SCGLY) was busy unwinding billions in improper trades made by one of its futures traders.

The $7 billion loss SocGen reported Thursday was itself helping to feed the global sell-off on Monday. Ritholtz said he believes the Fed was "suckered" by the market problems tied to SocGen. Others say even if that wasn't the case, the perception is bad for the central bank.

"It looks like the Fed wasn't reacting to economic moves but market movements, and we've since learned that much of the volatility is due to a rogue trader," said David Kelly, chief market strategist for JPMorgan Funds.

Too much, too late? Kelly is one of those economists who believes the Fed should have already cut rates further than it has due to economic conditions. But he and some other economists who believe that that further Fed rate cuts are justified argue the way the Fed is reacting to market problems is a problem in and of itself.

"The issue here is less what's been done but how it's been presented," said Lou Crandall, chief economist for Wrightson ICAP. "The presentation is a problem right now because of the perception that the Fed is following rather than leading."

The Fed does not automatically follow fed fund futures in its decision making process. Futures didn't do a good job forecasting monetary policy in much of 2007. As recently as the December meeting, the Fed bucked markets by delivering a quarter-point cut when many investors were betting on a half-point move.

But even some of the harshest critics of the Fed say it has no choice but to go ahead and give the markets what it wants at Wednesday's meeting, given what it has done leading up to the meeting.

"If they do less than that, there will be a widespread sense of disappointment or worse throughout the market and that's a headache the policymakers don't need at this point," said Tom Schlesinger, executive director of the Financial Markets Center, a think tank that focuses on the Fed.

Even Ritholtz agrees that the market would have a "hissy fit" if the Fed doesn't deliver another half-point cut on Wednesday and that the Fed can't afford to let that happen.

"At a certain point, the Fed has to break the markets from their addiction from cheap money. But this is probably not the time they need to do that," he said. To top of page