Mark Thoma channels Tim Duy on the possibility of a Fed interest rate cut

From Economist's View - Fed Watch: Waiting for the Inevitable (Tim Duy)

As I noted yesterday, the Fed let the genie out of the bottle last week; rather than dissipating expectations for a rate cut, the statement had the exact opposite effect. Analyst after analyst is lining up to predict not just a cut, but the beginning of a rate cutting cycle. It is tough to see how they can avoid delivering at this point:
The Fed does not want to cut rates; they are searching for a middle ground between maintaining their inflation concerns while promoting stability in the financial markets. Consequently, I do not believe the Fed’s discount rate cut was intended by policymakers to be simply a symbolic move. I think the Wall Street Journal summarizes the Fed’s intentions quite succinctly with:

In essence, the Fed is following advice that British journalist Walter Bagehot offered in his 1873 book, "Lombard Street," a copy of which Mr. Bernanke kept on a shelf when he was Princeton professor. In times of "internal discredit" -- when uncertainty leads private players to pull back -- the prescription to the central bank is: Lend freely.

Unfortunately, an effort to avoid cutting the fed funds rate at this point is hampered by at least four factors:
1. The credibility on the “subprime is contained” story is simply shot. That calls into question their judgment on the ultimate economic impact of the subprime turmoil. Now we need the data to confirm the Fed’s view, rather than giving the Fed the benefit of the doubt until that data arrives. The confirming data is weeks if not months away; market participants will read positive data as old news, while focusing on the weak data.
2. The failure of the emergency statement to mention anything about inflation leaves little room to suddenly turn around and scream “inflation” even if inflation holds above their comfort level. That credibility thing again. 3. The market has fully and completely embraced the rate cut story – note Monday’s amazing surge in short dated T-bills. If the Fed thought they were having a crisis of confidence last week, just see what happens if they attempt to verbally reverse the new expectations. 4. Cutting the discount rate may have very little impact, regardless of the Fed’s intentions. Not only is it widely viewed as just symbolic (regardless of the Fed’s intentions), it does not get to the heart of the matter, the question of the fundamental value of subprime-based assets. Moreover, commentators have noted that given funding alternatives, banks have little incentive to pay the penalty rate, and some believe that the banks that do go to the discount window are simply doing it as a show of support. In essence, the Fed may have nullified the effectiveness of the discount rate when it was changed to a penalty rate – the jury is still out....

Tough times for a Fed watcher – knowing the Fed wants to hold steady, but seeing the box they made closing in around them. It is difficult to see what combination of data and events will allow the Fed to hold steady in the months ahead at this point. The best chance for the Fed to avoid a rate cut (a cut they don’t want) is that both the financial markets remain calm and the August jobs report is very strong.

One thing I hadn't considered before, and which I haven't heard any analysts mention, is that at the current target for the federal funds rate (5.25%), monetary policy is probably mildly restrictive. The PCE deflator inflation rate was 2.3% over the past 12 months (on its way down from over 3% in 2006), so the real federal funds rate is currently about 3 percent. By contrast, here's the average real federal funds rate over some alternative time periods:

1982-2007: 2.8%
1987-2007: 2.3%
1992-2007: 2.0%
1997-2007: 1.8%

So assuming that past experience is a good guide to what you'd want to consider as a "normal" federal funds rate, the Fed may want eventually to reduce the federal funds rate by half a percentage point or more from its current level in order to return to a neutral monetary policy. The financial market turbulence and (mixed) signs of slowdown in the economy may give the Fed an opportunity to do this.