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Desperate Measures

Fed Under Fire after Huge Rate Cuts

By Stefan Schultz

In a drastic step, the Fed has lowered its key interest rate to 3.0 percent, the second large cut in two weeks. Critics warn that the move poses its own dangers -- and may even seduce banks into taking bigger risks.

Everything has its price, even money itself. And in the US at the moment, the price of money is dropping from week to week. On Wednesday, the Federal Reserve dropped its key interest rate by 0.5 percent to 3.0 percent, in a bid to counteract fears of a recession.

Within the space of two weeks, the federal funds rate -- the rate at which banks lend each other money -- has been dropped by 1.25 percentage points. It's a record intervention, one which simultaneously sparks both hopes and fears.

"The Federal Reserve is obviously very nervous about what is going on in the financial system and the housing market," said Mark Zandi, chief economist at Moody's Economy.com, in remarks to the Associated Press.

Some analysts were unsparing in their criticism of the move. "I think the Fed is bonkers," Allan Meltzer, an economist at Carnegie Mellon University, told the Los Angeles Times. Fed officials "frequently swear to themselves and to each other that they are not going to ease (interest rates) excessively, and then the economy slows a little and they do just that," he said.

The interest rate cut did little to boost markets on Thursday. Frankfurt's DAX fell by almost 2 percent on Thursday morning, while London's FTSE 100 dropped by 1.7 percent. "Markets are increasingly coming to terms that the Fed action is just not enough," one Europe-based trader told Reuters.

Meanwhile in Asia the reaction to the rate cut was mixed. Tokyo stocks fell in early trading but later recovered, rising by 1.9 percent, but Hong Kong's Hang Seng index fell by around 2.5 percent amid fears about the effect of severe weather on China's economy.

A Double-Edged Sword

Interest rate cuts are a double-edged sword. On the one hand, cheap money is a boon for the economy and stock market: If banks have access to cheap money, then theoretically companies should also be able to take out loans at better conditions. They can invest, which also tends to stimulate consumption, and hence boosts the economy as a whole. A low key interest rate also has a stimulating effect on the stock market.

But on the other hand, interest rate cuts -- especially extraordinary rate cuts announced between scheduled meetings, like last week's -- also raise fears. When the US Federal Reserve takes drastic measures, the inevitable suspicion arises that they know more than the rest of the world: Do they have data which shows that the economy is cooling faster than is feared?

Michael Schroeder, an expert in international financial markets at the Center for European Economic Research (ZEW), finds these fears quite understandable. "It is in fact the case that the Fed is usually the first to learn about changes in the economy and reacts accordingly," he told SPIEGEL ONLINE.

More significant than this diffuse anxiety are allegations by many analysts that the Fed's attempted cure is worse than the disease. With his policy of holding interest rates low, ex-Fed chief Alan Greenspan is accused by some of being partly responsible for laying the foundations for the subprime real estate crisis. The current Fed chief, Ben Bernanke, is now trying to solve this problem with renewed rate cuts.

Greenspan lowered interest rates 11 times in 2001 -- from 6.5 percent to finally just 1.75 percent. The following year, rates even fell to 1 percent (see graphic). By making these cuts, Greenspan saved the US economy, which had been shaken by 9/11 and the dotcom crisis, from disaster.

At the same time, he made money so cheap that Americans who would never have got credit before were suddenly being given loans -- and to an extent which exceeded any reasonable limits. "It's true that Greenspan cannot be accused of being responsible for the carelessness of the banks," Schroeder says. "But cheap money at least created the temptation for banks to issue risky loans."

Some experts are therefore arguing against a serious intervention in the economic cycle, even if the economy takes a temporary tumble. "The Fed's mistakes have been erring too much on the side of ease, creating circumstances where you had either excessive inflation, or a situation where there is an excessive boom that goes on too long," criticized Marvin Goodfriend, a former adviser to the Federal Reserve Bank of Richmond, in remarks to the news agency Bloomberg.

Anna Schwartz of the National Bureau of Economic Research in New York even accuses the Fed of outright failure. "The Fed neglected to address the obvious problems," the legendary 92-year-old economist told SPIEGEL.

Tempting Times

The parallel between Greenspan's and Bernanke's interest rate cuts is, however, difficult to sustain. The context in which interest rates are being lowered is very different in 2008 than in 2001. "Greenspan's low-interest rate policy was primarily aimed at the stock market," says Schröder. "At that time, he gave the investors, to a certain extent, a guarantee that the Fed would absorb a fall in the Dow Jones through interest rate cuts." As a result, investors were spurred on to take greater risks.

Bernanke's interest rate cut, however, "is clearly aimed at the economy," Schröder says. "He wants to prevent a recession, instead of inspiring speculation on the stock market." And that is clearly the right approach, Schröder feels. "If the Fed had done nothing, it would have hurt consumers most of all. But it's not the consumers who triggered the crisis."

However, in the context of the German economy, Schröder feels the German government is currently sending the wrong signals. "If, for example, WestLB gambles away billions and then the state ultimately helps it out of trouble, then that is much more problematic than an interest rate cut by the Fed. Because if it's the taxpayers who ultimately bear the bank's risks, then that is practically encouraging the banks to make careless investments."

In general, Schröder advises, the power of the Fed should not be overestimated. "An interest rate cut may boost the economy in the medium term, but it won't solve the problems of the credit crisis," he says. In this respect, it is much more the banks' responsibility to rethink their risky investment strategies. "It would also be helpful if financial institutions had to account more strictly for their risks on their balance sheets," said Schröder. But regulate that is the role of the government, not the Fed.