Martin Feldstein: No More Rate Cuts

Martin Feldstein says the Fed has cut the federal funds rate enough, further cuts will hurt the domestic economy more than they will help, and the cuts would have a negative impact on developing economies:

Enough With the Interest Rate Cuts, by Martin Feldstein, Commentary, WSJ: It's time for the Federal Reserve to stop reducing the federal funds rate, because the likely benefit is small compared to the potential damage.

Lower interest rates could raise the already high prices of energy and food, which are already triggering riots in developing countries. ...

Many factors have contributed to the recent rise in the prices of oil and food, especially the increased demand from China, India and other rapidly growing countries. Lower interest rates ... add to the upward pressure on these commodity prices – by making it less costly for commodity investors and commodity speculators to hold larger inventories of oil and food grains. ...

An interest rate-induced rise in the price of oil also contributes indirectly to higher prices of food grains. It does so by making it profitable for farmers to devote more farm land to growing corn for ethanol. ...

Rising food and energy prices can contribute significantly to the inflation rate and the cost of living in the U.S. ...[A] 10% rise in the prices of food and energy adds 2.5% to the overall price level. Commodity price inflation is of particular concern now that the CPI has increased 4% in the past 12 months. Surveys indicate that households are expecting a 4.8% rise in the coming year.

In lower-income, emerging-market countries, food and energy are generally a larger part of consumer spending. A rise in these commodity prices can therefore add proportionally more to the cost of living in those countries, and therefore depress real incomes to a greater extent than in the U.S.

Government actions to dilute these effects by increased subsidies on the prices of energy and food add to the government deficits, reducing the national saving available for investment in plant and equipment that would otherwise contribute to faster economic growth.

The rise in the U.S. inflation rate, and the adverse effects in emerging market countries, might be defensible if lower interest rates could significantly stimulate demand and reduce the risk of a deep recession. But under current conditions, reducing the federal funds interest rate from the current 2.25% by 50 or 75 basis points is not likely to do much to stimulate demand.

The current conditions in the housing industry and in credit markets mean that ... with the massive inventory of unsold homes ... a further cut in the fed funds rate would have little effect on housing construction. Moreover, lowering the fed funds rate has not brought down mortgage interest rates. ...

Economic recovery will require resolving the difficult problems of the credit markets, dealing with the millions of homeowners who may now be tempted to default on mortgages that exceed the value of their homes, and reducing the risk that the ongoing decline in house prices will push millions of additional homeowners into a vulnerable, negative equity condition. A lower fed funds rate will not solve any of those problems.

I've shared Feldstein's concern that lowering interest rates won't do much to stimulate the economy from the onset of the crisis, so I think we should continue to look for and implement non-traditional policy solutions designed to restore the flow of credit and to stimulate aggregate demand. Even so, I'd be willing to take rates a bit lower if conditions continue to deteriorate.