Fed attacks in the face of uncertainty

Pity the Federal Reserve. Given extreme uncertainty about the trajectory of the US economy, it is like a poker player in a hand with a big pot and every player still in: placing a monetary policy bet takes luck as much as judgment. A sound case can be made for the Fed's aggressive interest rate cuts of 125 basis points in eight days, although a sound case could also be made for a more gentle approach.

The question is whether financial market troubles will create feedback loops in the economy. If falls in house prices increase credit losses at banks, which reduce mortgage lending and so create further drops in house prices, then a deflationary spiral could take hold. Equally, it might not. That uncertainty, and uncertainty about whether monetary policy will work at all given the parlous state of the banks, makes a sensible strategy hard to formulate.

The Fed's decision to cut rates to 3 per cent suggests its concerns have become a great deal more serious. Even given the problems in the banking system, interest rates at this level are certain to stimulate the economy over time. At the very least, some subprime mortgages will not reset to such high rates as they might have done, while low Fed rates will also trigger demand for mortgage refinancing.

The risk is that the economy recovers quickly, and today's monetary stimulation turns into rapid inflation in the future. So far, inflation expectations look to be under control, but that could change in the blink of a trading screen if the economy turns the corner. The Fed's poker game is for high stakes.

The abandonment of a gradualist approach to changing interest rates - moving them up or down by 25bp every month for months - is sensible. Shocks to the economy are not evenly distributed or equal in size, and there is no reason why the monetary policy response should be either. If a central bank thinks rates of 3 per cent are appropriate, then it should move them there at once.

The Fed should, however, avoid the kind of lurch in its thinking that produces a 125bp cut if at all possible. It implies that previous policy was wrong - and that risks creating a sense of panic.

The Fed has more data than anyone on the state of the US economy, and, given the uncertainties, the only choice is to trust it to run the risks it judges necessary. Neither faith in the dollar nor in the Fed's inflation-fighting credentials have collapsed so far. But the US central bank must stand ready to raise interest rates as fast as it lowered them once the economy starts to recover.