Don’t fight the Fed has always been a dependable adage on Wall Street – and an even more reliable formula for understanding the world economy. But what happens when the Federal Reserve Board dares not fight the financial markets? The politically powerful executives now fighting to defend their jobs on Wall Street seem to believe that the US central bank has a moral obligation to keep cutting interest rates to boost the share prices of the banks, brokerage houses and insurance companies that have been struggling since the summer, even while most other American businesses have been performing extremely well. With the corporate upheavals now gripping Citigroup, America’s largest financial company, the question of whether the Fed steers Wall Street or Wall Street steers the Fed is about to be tested.

Given the appalling judgment revealed by so many of Wall Street’s top executives, in contrast with the generally good economic management delivered by the Fed, one can only hope that this contest will soon be decided in the central bank’s favour. But this is far from certain, especially because of the intellectual influence of financial economists who dominate the media headlines and airwaves with their self-serving predictions of gloom and doom, which apparently justify demands for much lower interest rates. The fact is that the quarter-point cut in interest rates announced by the Fed last Wednesday should already be sufficient to ensure the moderate acceleration of growth that the US economy needs to achieve in the second half of next year. The Fed Funds rate has been reduced by three quarters of a point since September, exactly equal to the easing undertaken in the US economy’s previous two mid-cycle slowdowns in 1995-96 and 1986-87.

A more radical monetary easing would be justified only if the US and world economies were in the depth of recession. Given that the US economy is growing quite strongly, while the global economy is booming, a radical easing now would intensify potential inflation problems and add fuel to a global boom in commodity and asset prices that is already getting out of control. Yet because of the specific sector problems that are largely confined to housebuilding and mortgage banking, financial economists in America are promoting a different message. They suggest that the whole US economy is on the brink of recession, if not depression, and that the Fed should slash interest rates much more aggressively and rapidly, as it did in the recessions of 2001-02 and 1990-91. For the Fed to bow to such pressures for aggressive monetary action would be dangerous and futile, because it would do very little in the short term to revive the weak spots of the US economy – the financial sector and the low end of the housing market. Instead, it simply would fuel a potentially explosive inflationary boom in 2009 and 2010.

Monetary policy typically acts on economic activity with a lag of about 18 months and affects inflation another 6 to 12 months later.

In the previous US economic cycle, for example, the Fed started raising interest rates in June 1999, but it was not until late 2000 that the economy dipped into recession. It was also roughly 18 months between January 2001, when the Fed started cutting interest rates to pull the economy out of recession, and October 2002, when a full-scale recovery began.

The same length of time elapsed between the start of the next round of Fed tightening, in June 2004, and the present slowdown in the US economy, which began early last year. Given that the Fed started easing only two months ago, it is hardly surprising that there are still ambiguities in the evidence of an economic rebound starting to appear in US statistics.

What is surprising is that the Fed has allowed itself to be forced by panicky market sentiment into pursuing a monetary policy that its own leading officials probably believe to be unwise. The statement from the policymaking Federal Open Market Committee that accompanied last week’s quarter-point rate cut could hardly have been clearer. The FOMC was clearly reluctant to undertake this easing when oil and commodity prices were soaring to daily records and inflationary expectations were still rising.

The very strong growth rate of 3.9 per cent reported for US GDP just before the Fed announcement, followed by a surprisingly strong employment figure on Friday, made the case for a monetary easing even less convincing. Ben Bernanke, the Fed Chairman, could not possibly have justified this easing on the basis of the new “more transparent” and “data dependent” approach that he claimed to be following only a few weeks before.

The Fed eased last week only because Mr Bernanke had allowed market expectations to get so one-sided that failing to deliver a rate cut might have triggered a financial meltdown – and after the credit crisis of early August, this was a risk the Fed Chairman presumably was not prepared to run. Mr Bernanke cannot afford to let himself be trapped in this way again.

At present, the bond prices on Wall Street are assuming at least two further rate cuts between now and the end of the first quarter. To restore the Fed’s freedom of manoeuvre and his own reputation, Mr Bernanke will have to remove these expectations. The best way for him to do this would be to make some hawkish statements underlining the Fed’s refusal to protect companies such as Citigroup and Merrill Lynch from the consequences of their management mistakes.

In the weeks ahead the Fed will have to take an interest not only in the state of the US economy but also in the campaign by Mervyn King, the Governor of the Bank of England, against the “moral hazard” of bailing out imprudent bankers. At the height of the credit crunch this summer, the Bank should have shown greater flexibility and more willingness to follow the Federal Reserve’s example. But now it is time for Mr Bernanke to learn some lessons from Mr King.

anatole.kaletsky@thetimes.co.uk

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