Has the Fed faltered?

50-50-50?

In response to the housing sector's subprime mortgage and related asset-backed defaults, the Fed has both decreased benchmark, short-term interest rates and also provided liquidity through a term auction facility, to both stimulate economic demand and maintain the orderly function of the markets.

The Fed has cut benchmark interest rates three times, starting in September 2007. The Fed funds rate, the rate banks charge each other, now stands at 4.25%, and the discount rate, the rate the Fed charges banks for short-term loans, is at 4.75%.

In addition, the Fed, in consultation with the ECB, the Bank of England, the Swiss National Bank, and the Bank of Canada, also injected $40 billion via auctions. (Further, the companion central banks took related actions, including The Bank of England's decision to accept of a wider range of collateral on three-month loans). The Fed also established a term auction facility and a foreign exchange swap line with the European Central Bank and the Swiss National Bank.

Affinito said the Fed "has done a good job on the liquidity front, as it relates to major financial institutions, but the evidence is mixed on the short-term interest rate front, as it relates to the consumer."

"The Fed should have been more assertive regarding rate cuts," Affinito said. "Given the headwinds the economy is facing, I'm arguing that they should have already cut 50-50-50 for a total of 150 basis points. I don't think there's enough stimulus in the economy right now, and there's a 70% chance we'll fall into a recession this year."

The Stimulus Factor

Affinito cited one macroeconomic theory that argues that at the first definitive sign of a recession monetary policy should be eased substantially, and quickly, to pump-prime demand and commercial activity. The downside, of course, is too much stimulus that increases inflation, but Affinito said the check would be a re-raising of rates slightly, later, if the Fed determined that slightly more stimulus had been applied than was needed. In Affinito's view, and the view of other economists, the negative economic consequences of a recession after failing to cut rates enough are far greater than the consequences of cutting rates too much.

Housing's correction, high oil prices, stagnant wage growth for many job categories, and higher health care costs are acting to stifle U.S. GDP growth, if not already contract the U.S. economy, Affinito said -- headwinds that are too large for the Fed not to respond with larger rate cuts, in his interpretation.

"The Fed sided with inflation fears and chose to calibrate monetary policy incrementally, but if the economy falls into a recession, there will be criticism that the Fed's failure to act boldly helped create the recession. It's a valid criticism, in my view," Affinito said.