The chart below shows the real level of the US Fed funds rate, defined with respect to the annual change in the consumption price index excluding food and energy – the Fed’s favoured inflation measure. After yesterday’s cut the real Fed funds rate stands at just 0.8%.

Real Fed funds peaked at a lower level in the current cycle than before the last six recessions. This has been one factor preventing my recession probability indicator from breaching the 50% “trigger” level.

As the chart shows, a real Fed funds rate of 0.8% was reached only near or even after the end of prior recessions. (In one case – the 1981-82 recession – it bottomed well above this level.) The shortest interval between the onset of a recession and real Fed funds reaching 0.8% was five months (in 1980). 

Pessimists argue that the economy entered a recession in November or December. Employment trends will be a key influence on the determination of the official arbiter, the National Bureau of Economic Research. Tomorrow's offical numbers will provide more information but the solid ADP payrolls report for January suggests employment has yet to turn down, implying the pessimists’ case is weak.

The Fed has embarked on an extraordinary monetary policy experiment, cutting official rates to post-recessionary levels when there is still little compelling evidence that a contraction has actually started.

One risk with this strategy is that the Fed is squandering ammunition that would be better reserved until significant economic weakness is confirmed. Premature easing may have boosted inflationary pressures with little positive impact on the real economy – see here.

The alternative risk is that the Fed is too pessimistic about economic prospects and combined monetary and fiscal stimulus will produce a strong rebound later in 2008, pushing inflation further above target. Anyone under any illusions about the Fed’s superior forecasting ability should read Chairman Bernanke’s monetary policy testimony to Congress in February 2006, containing the memorable phrase “a modest softening of housing activity seems more likely than a sharp contraction”.

Political and Wall Street pressure on the Fed is enormous but I think these risks warranted more measured cuts.

The headline balances from January’s CBI distributive trades survey are unremarkable, suggesting a slowdown but not collapse in retail spending. However, some worrying developments are buried in the detail of the report.

Specifically, wholesale traders have reported a sharp rise in stock levels in December and January and have cut back their orders with suppliers accordingly. Few economists bother to look at these series but weakness in wholesale orders usually signals deteriorating manufacturing prospects – see chart below.

I still favour a moderate growth slowdown this year rather than serious economic weakness but this is troubling news. Let’s see if there is any confirmation in the January purchasing managers’ manufacturing survey due on Friday.

Recent falls in share prices of US financial companies can be compared with the bear market associated with the savings and loan crisis of the late 1980s.

According to a General Accounting Office study, the S&L crisis cost $160 billion to resolve, equivalent to 2.9% of US GDP in 1989, when the bear market in financial stocks began. The equivalent percentage of GDP in 2007 would be $400 billion.

Will the subprime crisis inflict damage on this scale? Some estimates of the eventual losses are even higher but care is needed in the comparison, for two reasons. First, S&L damage was largely confined to the US, whereas foreign institutions have borne a significant portion of subprime losses. Secondly, the GAO estimate refers only to the cost of the rescue operation and excludes losses suffered by creditors and equity-holders of insolvent S&Ls.

It seems reasonable to assume that losses suffered by US financial institutions as a result of the subprime debacle may approach but will not exceed those of the S&L crisis. On this basis, the late 1980s bear market in US financial stocks may represent a “worst case” scenario for current events.

The chart below overlays the 1989-90 fall in US financial share prices on the current decline. (It is based on weekly closes and the peaks in February 2007 and October 1989 have been aligned and rebased to equal 100.) Four observations are:

1. Financial share prices would have to fall a further 15-20% from current levels to match the 1989-90 decline.

2. The comparison suggests a bottom may be in place by March.

3. Share prices recovered strongly in late 1990 and 1991, regaining their prior peak within nine months of the trough.

4. The 1990 recovery began following five cuts totalling 125 bp in the Fed funds rate; the funds rate has already declined by 175 bp in the current easing cycle and markets expect a fifth reduction this week.

Risks remain high but the 1989-91 experience suggests a significant buying opportunity is brewing.

Has the Federal Reserve received new information, not yet in the public domain, that might justify Tuesday’s shock interest rate cut?

One of the stated reasons for the move was that “credit has tightened further for some businesses and households”. The Fed conducts a quarterly credit conditions survey of senior loan officers at banks, with the latest results due to be released in early February. Officials are likely to have been given an early view.

The chart below shows an indicator of corporate credit conditions derived from this survey that has warned of recessions historically. (It is an average of the percentage balances of loan officers reporting tighter standards on commercial and industrial loans to large / medium and small firms.) On the last reading, the indicator was rising but still significantly below the historical recession “trigger” level. Has it surged further in early 2008?

Even if it has, I still think the Fed acted unwisely by appearing to have been panicked by global equity market falls. Investors are now banking on further action at next week’s meeting, creating another dilemma for policy-makers.

The MPC voted 8-1 for unchanged rates at this month’s meeting, a less dovish outcome than forecast by my MPC-ometer. However, the minutes suggest greater concern about a weakening economy than poor near-term inflation prospects, while some members appear to have delayed voting for a cut in order to avoid back-to-back moves and because of the imminent February forecasting round. A reduction looks highly likely next month but economic and financial indicators would have to deteriorate dramatically over the next two weeks to generate an MPC-ometer forecast of a 50 bp move.

The Eurozone purchasing managers surveys weakened slightly further in early January – see chart. Feeding the relevant components into my ECB-ometer model produces an average interest rate recommendation of -2 bp for the February ECB meeting – consistent with a shift to a mild easing bias but insufficient to generate a forecast of an actual rate cut (see here and here for more explanation of the model). The Governing Council is likely to issue a more balanced policy statement at the next meeting but it may be several months before a consensus forms in favour of lower rates.

Of course, both the MPC and ECB could be forced to accelerate action if equity markets continue to spiral lower.

I am not a fan of the Fed’s “surprise” 75 bp rate cut, for three reasons.

First, it is far from clear that the economy – as opposed to Wall Street – requires such dramatic stimulus. Available evidence suggests GDP expanded in the fourth quarter. Real interest rates were not high before today's action and the Fed did not feel the need to cut by more than 50 bp in a single move in the last two recessions. (The last decline in the Fed funds target rate of more than 50 bp occurred in August 1982, when the economy had been contracting for over a year.)

Secondly, cutting rates nine days before a scheduled policy meeting creates the (probably correct) impression that the Fed has been panicked into action by global equity market falls. Investors will now expect further reductions if equities continue to weaken, regardless of the wider economic context.

Thirdly, the move leaves the Fed’s reputation as an inflation-fighting central bank in tatters. The statement issued after the December meeting warned that “some inflation risks remain” and subsequent news has confirmed that assessment. Premature easing risks boosting inflationary pressures without any positive impact on economic activity (see here).

The Fed’s move has led to speculation about a 50 bp reduction in UK rates at or even before the MPC meeting on 7th February. My MPC-ometer model suggests a cut of no more than 25 bp is warranted by current economic and financial indicators. The MPC rejected calls for easing earlier this month from distressed retailers; it should be similarly sceptical of demands for “emergency” action from financial operators.