Too much, too late? Guest post by Adam Posen

I've been down under at the Reserve Bank of Sydney for the past three weeks, anxiously watching yesterday's market meltdown and today's Fed's reaction. Here's what my co-conspirator Adam Posen, Senior Fellow at the Peterson Institute, had to say about recent developments:

Today's 75 bp surprise rate cut will in the end probably prove to be too much, rather than too little. At present, however, the point is to get in front of events and financial market panic rather than to fine tune to the forecast. The lesson of Japan in the 1990s is in the forefront of the FOMC's collective mind -- that is, one has to be activist and take downside risks seriously rather than being paralyzed by inflation risks and ending up with a worse outcome.

There is a communications issue here, created by the FOMC's decision to cut rates between meetings rather than waiting until next week's regularly scheduled meeting. It makes it look as though stock market fears are driving the Fed to action. Because a sharp decline in asset markets, particularly if synchronized outside of the US, could have effects on the real economy, it is reasonable for the Fed to try to stave off such a self-fulfilling prophecy. But now they risk being seen as bailing out equity investors (rather than responding to the forecast or liquidity needs) and being seen as ineffective if the markets continue to fall in the immediate period.

I don't envy being in their position as of 7 a.m. this morning, but ideally I think they should have issued a statement indicating that they would cut big on Jan 29/30 as expected, but that there was/is no new negative information besides the equity market moves themselves. Or if they had new information (which the statement seems to imply about housing markets even though the recent Beige Books and moves in spreads seem to give a more balanced picture), they should have spelled out what that new information was. In the end, this kind of timing and communications issue will not matter much.

The outlook is still not as bad as people seem to think, and we're still looking at either slow growth in first half of 2008 with no recession or a mild brief recession. I put my money so to speak on the former, and the combination of monetary ease and fiscal stimulus being quite effective over the next several months to rule out the downside risks. The bipartisan principles on the fiscal stimulus package (temporary, targeted, ~1% of GDP and high-multiplier form) are the right ones - especially if direct rebates to low-income people (instead of tax credits) accompany small business favoring investment tax credits. I have no idea what the "markets" are talking about suggesting they expect this to be ineffective - as Ken Kuttner and I showed, fiscal stimulus did work in Japan in the 1990s when tried, and there the financial system was in much worse shape and monetary policy was going in the opposite direction.

So I expect us to see the Fed having to reverse its cuts by year-end of 2008. That means I expect the US to be heading back close to trend growth (now 2.5% real year-over-year) in the second half of the year, with core inflation above 3%. Unemployment will be a lagging indicator, as usual, and so will creep up towards 6% months after the economy turns around, making it politically difficult for the Fed to raise rates. But the new President will likely be fortuitous in her/his timing, with perceptions of the economy hitting a nadir around June, and evidence of a recovery becoming clear around the time of her/his first budget if not State of the Union address.