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.

An earlier post compared the path of world equity prices in the current economic downswing with average experience in six “soft” and six “hard” landings over the last 40 years. At the time of the post equities were following the historical soft landing path closely.

The first chart below updates the analysis to take account of the recent market plunge (the latest data point refers to Friday’s close). Sentiment has clearly shifted, with current prices implying a high risk of a hard landing. This fits with other evidence of increased economic bearishness: for example, the Intrade US recession probability contract has risen to 70%.

While markets have moved to discount a hard landing, monetary conditions have been easing. As shown by the second chart, our monetary leading indicator picked up further in early January, reflecting lower LIBOR rates. Near-term economic weakness is baked in the cake but monetary factors will be lifting activity later in 2008 and in 2009.

The US economy may yet avoid a recession. The third chart shows that business inventories normally rise significantly before recessions start but are currently at a record low relative to sales. Weekly jobless claims are still averaging less than 350,000 – a rise towards 400,000 is needed to confirm a contraction.

Recession fears focus on the housing market and consumer spending. Interestingly, the S&P homebuilding index held above its early January low amid last week’s equity market carnage. Wal-Mart’s share price – which tends to correlate with retail sales – also remains strangely resilient.

Even if a hard landing is confirmed, the first chart suggests equity markets should find support not far from current levels. Additional considerations are moderate valuations and plentiful global liquidity. Of course, the hard landing average includes some larger declines – nothing is guaranteed – but equities look increasingly attractive in risk / reward terms.