What Should the Fed Do Tomorrow?

In the last section of my September 13 posting — Some Thoughts on the Credit Crunch — I made the case for front-loading monetary policy when it's changing direction, which would be the case at the September 18^th meeting of the FOMC.  That argument is especially strong when an element of financial crisis is present, as was the case.  In effect, I called for a 50 basis point cut in the fed funds rate (and discount rate), and concluded that posting as follows: "Under present circumstances, shock and awe is warranted."

The FOMC's bold move accomplished its purpose:  it calmed markets and bought some insurance against a severe recession.  While some additional insurance may be warranted tomorrow, it need not — and should not — be bold.  Healing has begun and a quarter-point follow-up should be sufficient to indicate the Fed is still awake and on the case.  In fact, the more we know about the nature of the credit crunch, the less the Fed's tools seem relevant.  If lenders are afraid to lend because they are afraid they won't be repaid or because they can't trust the collateral, a small difference in short-term market interest rates hardly matters.  This is going to take time.

Another consideration likely to loom larger tomorrow by many commentators will be the decline in the dollar and possible Fed reluctance to contribute further to it.  My educated guess is that that won't be a major consideration in the FOMC's deliberations. They are happy to have flexible exchange rates reconcile what they regard as proper policies for the internal economy to the external world.  Sure, they would prefer a stronger dollar, as would I, but when it comes down to trade-offs, the dollar will not be the highest priority.  To them, protecting the value or purchasing power of the dollar means keeping its domestic purchasing power — not purchasing power of foreign currencies.

Guests on financial talk shows frequently say they prefer a strong dollar as if they can order one off the menu as an appetizer along with an entrée of rapid growth and a dessert of price stability.  That restaurant is not in my neighborhood.  If the markets have finally decided that the unsustainable current account deficit really is not sustainable, and that the alligator finally has to be paid, then the realistic choices are:  hold up the dollar and let the economy sink far enough to curb import demand (in other words a sharp recession) or try to keep both the economy and the dollar strong by backsliding on free trade and investment.  Over time, maintaining a strong, and perhaps more importantly, an economy with excellent prospects going forward, is the best that policymakers can do for the dollar.

Most people miss an important distinction between the role of the dollar in trade and the role of the dollar in foreign investment.  For trade purposes — a one-shot transaction — the level of the dollar matters.  The lower dollar makes imports more expensive to us and our exports less expensive to our trading partners.  But for foreign investors contemplating investing in the U.S. — a two-shot transaction — the important thing is what happens to the dollar during the investment period.  Once the dollar becomes cheap enough for investors to conclude that appreciation is more likely than further depreciation, then they have an incentive to invest here, even if the dollar is still "low."  That point may be near (or here already) for all I know.  If so, the capital inflow that offsets a large current account deficit could return and keep the alligator at bay a while longer.

Let me close with a quote from the Flatlanders:

It might be sooner
And it might be later
But one thing's for sure
You gotta pay the alligator.