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Posted January 30, 2008
in Federal Reserve

With Another Rate Cut, The Federal Reserve May Be The Proverbial “Fool In The Shower”

The Federal Reserve may be the Fool in the Shower.  Additional Fed Funds Rate cuts could lead the economy into runaway inflation.

Changes to the Fed Funds Rate literally takes months to work their way through the economy.  That's one reason why the Federal Reserve is in a difficult position today.

After cutting the Fed Funds Rate by 1.750% over the last four months, the FOMC is expected to cut the benchmark lending rate again today.  This would occur despite the fact that Fed has yet to see the cumulative effect of its policy changes.

There's a very real chance that today's additional rate cut will (someday) push the economy into a rapid expansion characterized by runaway inflation.

There are two main reasons why may happen:

  1. The Federal Reseve can't tell where the economy "is" except in hindsight
  2. Markets don't react to change overnight

In other words, by the time the Fed recognizes that the economy is expanding too quickly, the expansion is already well under way.  It's hard to stop a train that's moving at full speed.

In economics, this challenge is called "recognition lag".  It says that policy makers can't immediately identify our current market because economic data is historical, not predictive.

To matters more challenging, when the Federal Reserve makes a cut to the Fed Funds Rate (Point A), the change is not felt by the economy straight away; it takes some times for the economy to adjust to new market conditions.

We call this condition "response lag" and, during the response lag period, the Federal Reserve will meet several more times.  Even while it's dealing with the response lag.

Despite the uncertainty, the voting members of the Fed usually choose to implement additional policy changes (Points B and C) to stimulate the economy.  These aren't immediately reverberated through the economy, either.

So, by the time the Fed Funds Rate cuts are felt, they tend to magnify the natural economic recovery of the nation.

On the chart this is represented by Point E1, Point F1.  Instead of a "normal" path, you can see that the curve follows a new growth curve that exaggerates the upcoming business cycle.

Economist Milton Friedman referred to this scenario as the "fool in the shower".

When the fools turns on the shower, the water is very cold.  So, he turns on the hot water.  Only the hot water doesn't come on right away so he turns it on full blast.

Before long, the water gets very hot, very fast and scalds him.  Reflexively, he dials back the heat only to find that he's too cold again.

If you've ever taken a shower, you know what Friedman meant.

Fed Funds Rate cuts are meant to stimulate growth, it could be at least 12 more months before we'll find out if the recent slashing actually worked.  And yet, today, at 2:15 P.M. ET, the Federal Reserve Open Market Committee is expected to lower the Fed Funds Rate for the fifth time in four months again.

With another broad cut, the Federal Reserve may epitomize Friedman's "Fool in the Shower".  And lead us into runaway inflation.

The information contained on The Mortgage Reports website is for informational purposes only and is not an advertisement for products offered by Full Beaker. The views and opinions expressed herein are those of the author and do not reflect the policy or position of Full Beaker, its officers, parent, or affiliates.

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