Can Fed talk the talk without walking the walk?

Last November, Federal Reserve Board member Frederic Mishkin told economics undergrads at MIT that he wished everybody would stop being so obsessed about what the Fed's Open Market Committee (FOMC) would do with short term interest rates at its next meeting.

What's important, Mishkin said at the time, is not what happens at any particular FOMC meeting, but the path of monetary policy over time. Mishkin was speaking about the Fed's decision to provide more information about the committee's decisions, so financial markets would have better idea of how its members were thinking and how they might react to future developments.

The committee, which meets about eight times a year, has lowered its target for the federal funds rate and the discount rate at its last three meetings in an attempt to prevent the crisis in mortgage lending from dragging down the economy with it.

But some feel the Fed hasn't moved fast enough. Mishkin, in his latest policy speech, seems to agree.

The FOMC "has not been basing its decisions solely on the incoming flow of economic data," Mishkin said Friday, noting that it's been cutting rates even though third quarter GDP growth was strong.

"Rather, our policy approach has reflected the rapid deterioration of financial market conditions, which has contributed to a worsening of the economic outlook and the emergence of pronounced downside risks to economic growth and employment," Mishkin said.

He also seems to think that the committee -- which cut the federal funds overnight rate by 50 basis points in September, but then went with more conservative 25 basis-point reductions in October and December -- may need to take more drastic action.

"I believe that financial disruptions of the sort that have been experienced in recent months tend to have highly nonlinear effects on the economy," Mishkin said in his latest speech. "Thus, compared with the standard case, optimal policy may well involve much more rapid adjustment -- a pattern that I will refer to as policy flexibility."

Fed Chairman Ben Bernanke has been making similar noises (see story), "deliver(ing) the leadership demanded by his critics" and "put(ting) himself at odds with more hawkish members" of the board by "depart(ing) from his hitherto consensus-based approach to monetary policy" Retuers' Alister Bull observes.

While stock market investors have been screaming for what we are apparently going to see next -- a 50 basis point reduction in the federal funds rate -- some members of the committee are worried that such drastic measures will unleash inflation. It could also send mortgage rates up, mortgage broker and syndicated columnist Lou Barnes writes.

In a forecast out today, Doug Duncan, the chief economist for the Mortgage Bankers Association, sees rates on 30-year fixed-rate mortgages climbing to 6.2 percent by the fourth quarter of 2008 and edging up slightly through 2009 (see Inman News story). That would still leave mortgage rates at near historic lows, but any increase in rates mean less buying power for would-be homebuyers -- the last thing housing markets need.

While Duncan sees the Fed cuttting rates at this month's meeting, he expects them to hold the line there, while "say(ing) less about inflation ... and more about the need to do what is necessary and possible to keep the economy away from the brink of recession." In other words, the Fed could send those who fear a recession a signal that it feels their pain, without raising the risk of inflation (and higher mortgage rates) by actually making further rate cuts.

That may not assuage critics who don't have the patience for Mishkin's argument that what's important is not what happens at any particular meeting, but long term monetary policy.

But the Fed has to not only weigh the risk of recession against the risk of inflation, but balance the short-term interests of stock market investors against the long-term prospects of the housing market.

A 50-basis point cut in the federal funds rate seems like the most likely outcome of the FOMC's next meeting to the 100,000+ respondents in this Yahoo! Finance poll. Only 5 percent think the Fed will hold off on a rate cut, while 56 percent are expecting a 50-basis point cut and 11 percent are forecasting (dreaming of?) a 75-basis point cut.

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