We know what we're doing

If you believe half of what you read, it's a foregone conclusion that the Federal Reserve's Open Market Committee will cut its target for the federal funds rate -- the rate banks charge each other to loan money overnight -- on Sept. 18, perhaps by as much as 50 basis points.

But read what those who are going to make the decision next week are saying, and you have to wonder. Do these sound like people who have made up their minds to cut the federal funds rate, or are they still playing chicken with inflation?

All of these quotes are from speeches made today:

"Inflationary pressures have softened somewhat in recent months. Inflation expectations remain well contained. By some measures, the pace of inflation is now around 2 percent. In my view current readings of inflation represent progress, but not victory. I would like to see inflation sustained at a somewhat lower rate—with emphasis on 'sustained.' "

--Dennis Lockhart, President Federal Reserve Bank of Atlanta (text of speech)

"...the main question is that monetary policy’s unswerving focus should be on pursuing the Fed’s mandated goals of price stability and full employment. Monetary policy should not be used to shield investors from losses. Indeed, investors who misjudged fundamentals or misassessed risks are certain to suffer losses even if policy is successful in keeping the economy on track."

-- Janet Yellen, president, Federal Reserve Bank of San Francisco (speech)

"Conducting monetary policy is not a popularity contest ... the standard tools of monetary policy are insufficient, by themselves, to deal with the subprime market fallout."

--Richard W. Fisher, president, Federal Reserve Bank of Dallas (speech)

Expect all hell to break loose on financial markets if the committee sticks to its guns and leaves the federal funds rate at 5.25 percent.

Fisher seems to be anticipating just that:

"In recent weeks, we have heard much about financial market turbulence. We've been distracted by the noise of the subprime fallout, periodic reports of a "seizing up" in asset-backed commercial paper markets, volatility in the stock market and tremors in other parts of the financial infrastructure. (Apparently it is no longer true that, as Andrew Mellon once famously quipped, "Gentlemen prefer bonds.") Amidst this clamor and drama, some might have lost sight of our economy's great resiliency."

...

"As we approach the upcoming session of the FOMC, each of the participants, including me, is diving deep into the data and taking soundings from business leaders, bankers and others with operating ears to the ground to ascertain the current pace of the economy and—this is important—the prospective dynamics of growth and inflation. I am particularly active on this front. Before each meeting, I speak with around 30 CEOs and CFOs of a careful selection of large and small companies from around the country in order to get an in-depth understanding of the pace of economic growth and price pressures they see through their businesses. Meanwhile, our staff routinely surveys a broad base of businesses within our district and reports their findings in what is known as the Beige Book, the most recent of which was released last Wednesday. Lately, I have focused on how recent developments in financial markets are impacting the revenues and costs, supplier and customer dynamics, product mix and growth projections of these hands-on operators of our economy. I am only partway along in studying the entrails of the Beige Book and a third of the way through my CEO and CFO conversations and have not yet reached any conclusions. However, it is fair to say that I am encouraged by what I have heard against a background of constant negative speculation and the occasional discordant note, such as last week's employment numbers. Our economy appears to be weathering the storm thus far. The future path of that storm and the appropriate policy course, however, are still to be determined."

...

"What guides me at the table is pretty straightforward. One of my four children is here today, my son Miles. Whenever I sit at the FOMC table, I am mindful that the entire transcript of our deliberations will be released in five years. I think about what Miles and his brother and sisters will think when they read their father's words in a historical context, removed from whatever the press and the markets may be clamoring about at the time of the meeting. I am guided first and foremost by a desire for my children to be proud of their dad; to be judged by them as well as by economic historians as having been wise rather than too smart by half, as having a steady hand rather than an itchy trigger finger. I set aside the passions of the moment and the conventional wisdom in the markets and keep a steady focus on the Fed's mission: to conduct monetary policy so as to achieve long-term, noninflationary economic growth for the great capitalist machine that is the United States of America. Conducting monetary policy is not a popularity contest.

All of this is a long way of saying that, in my humble opinion, the standard tools of monetary policy are insufficient, by themselves, to deal with the subprime market fallout. The best course, as Ned Gramlich reminded us, is to minimize the future threat to the economy while taking care not to strangle financial innovation and its benefits. He reckoned that over half the subprime mortgage loans in recent years were made by independent lenders who were not subject to federal supervision. Virtually all prime market loans, by contrast, are made by federally supervised banks and thrifts or their affiliates. Gramlich pointed out that "[i]n the prime market, where we need supervision less, we have lots of it," whereas "in the subprime market, where we badly need supervision, a majority of loans are made with very little supervision."

Only Yellen seems the least bit concerned about the potential for greater impacts on the economy at large:

"Beyond the housing sector’s direct impact on GDP growth, a significant issue is its impact on personal consumption expenditures, which have been the main engine of growth in recent years. The nature and extent of the linkages between housing and consumer spending, however, are a topic of debate among economists. Some believe that these linkages run mainly through total wealth, of which housing wealth is a part. Others argue that house prices affect consumer spending by changing the value of mortgage equity. Less equity, for example, reduces the quantity of funds available for credit-constrained consumers to borrow through home equity loans or to withdraw through refinancing. The key point is that, according to both theories, a drop in house prices is likely to restrain consumer spending to some extent, and this view is backed up by empirical research on the U.S. economy.

"Indeed, in the new environment of higher rates and tighter terms on mortgages, we may see other negative impacts on consumer spending. The reduced availability of high loan-to-value ratio and piggyback loans may drive some would-be homeowners to pull back on consumption in order to save for a sizable down payment. In addition, credit-constrained consumers with adjustable-rate mortgages seem likely to curtail spending as interest rates reset at higher levels and they find themselves with less disposable income."

But if Yellen is the most bearish member of the committee speaking out today, she doesn't sound too eager to cry "rate cut."

While I do think that the present financial situation has added appreciably to the downside risks to economic activity, we should remember that conditions can change quickly for better or for worse—especially in financial markets—so it’s hard right now to speak with a great deal of confidence about future economic developments. It’s also important to maintain a sense of perspective: past experience does show that financial turbulence can be resolved more quickly than seems likely when we’re in the middle of it.

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