Too much by half?

Or, stray thoughts on the economy

So who else is moderately shocked that the Federal Reserve lowered the federal funds rate by a gaudy half-percent?

Just last month, after the previous meeting of the Federal Open Market Committee, Chairman Ben Benanke reiterated the Board’s stance that inflation remained the economy’s chief villain, but obviously, the Fed has had a change of heart during the past month and has offered Wall Street an early Christmas present.

Predictably, the stock market rallied upon hearing of the rate shift, recording its greatest one-day gain in several years. Nine out of ten issues posted gains, proving that, caught in strong winds, even pigs can fly.

The financial services industry was especially buoyed by the good news, as the Fed’s action coupled with a relatively positive earnings statement from Lehman Brothers (the first big investment bank to report since the sub-prime crisis broke) pushed stock values up broadly—Goldman Sachs was up 6.87%, Merrill Lynch 4.08%, Morgan Stanley 5.55%, Citigroup 5.08%, and JPMorgan 5.59%. Companies in the Basic Materials sector also posted outsized gains, as everything from steel to copper jumped on the news.

Prior to the announcement, the consensus among fed-watchers in the business press signaled that a quarter-percent cut was imminent, and upon hearing of the half-percent cut (for both the federal funds rate as well as the discount rate), it left many commentators reassessing the strength of the US economy. Many reason that the US economy must be declining much more swiftly than most reckon to warrant such an aggressive response from the Fed. As I pointed out last month, there is a basket of indicators that suggest we may be in recession already, and from the Fed’s point of view, the risk posed by a rippling sub-prime crisis—on top of recently revised employment statistics for the summer months—was simply too great to ignore. And from one perspective, given the relative slowness of monetary policy changes to take effect, and the speed at which the broader economy seems to be slowing, perhaps the Fed’s half-percent move is warranted.

It will be interesting to see how the Fed parses economic data for the third quarter. Many speculate that the rate will drop another 25 to 50 basis points by Christmas. In any event, whether this move is a one-off or part of a new lowering cycle, it should help US exporters as the dollar will likely continue to weaken. It should also help square the US’s trade and account imbalances, but these are pretty abstract pros against some rather more concrete cons.

Inflation, naturally, tops the list of potential bugbears. Secondarily, if this cut establishes a new cycle for the fed rate, it could inflate (or reinflate) asset bubbles. There have been several folks of late to blame former Fed chairman Alan Greenspan for abetting the creation of both the dot-com bubble and the housing bubble by being overeager to cut the interest rate when the economy threatened a swoon. While I’m sure Greenspan’s actions contributed to a climate in which bubbles were more apt to form, I’m not sure it’s fair or accurate to lay blame exclusively at the Fed’s door. Greenspan, naturally, would agree. His new book, The Age of Turbulence, appeared Monday and attempts to explain the reasoning behind several of his more notable moves as chairman of the Federal Reserve. I look forward to reading it.

From an investor’s point of view, it will be interesting to see if the recent stock-market rally routs the bears from the scene. Somehow, I doubt it. Corporate profits have been historically high of late, and if history is any guide, one would expect to see those profits moderate over the next year, which should act as a drag on stock valuations.

Large corporations have long valued the cost-cutting potential of locating certain operations overseas. In this next cycle, with a cheaper dollar and better prospects for exporters, the biggest winners won’t be those companies that can make stuff overseas, but those that can sell, and I suspect many will discover that it’s a lot easier to set up a factory overseas than it is to tap into a foreign consumer market.