The Fed takes a gamble (but the Bank of England may be taking even more of a gamble...)

The US Federal Reserve panicked yesterday in the face of a global stock market slump and cut interest rates by 0.75 percentage points (or 75 "basis points" as the guys in the City like to say). That doesn't sound a lot, but given that they were only 4.25% to start with, it's a huge reduction. Also it was a week before the Fed's normal Open Market Committee meeting - which made it look even more like a panic move.

The States is desperate to avoid going the way of Japan over the last fifteen years, where the collapse of the huge 1980s asset bubble was followed by a prolonged economic slump. At one point interest rates in Japan fell to 0.1% - pretty much the lowest practically possible. Hence, fiscal and monetary stimuli are being applied - the interest rate cut on the monetary side, and on the fiscal side Bush has lined up a $145bn stimulus package of tax cuts. Naive Keynesian economic theory suggests that both these measures should have positive effects by boosting demand for goods and services and making it less likely that high borrowing costs will force firms into bankruptcy. However, naive Keynesianism also ignores a lot of other factors (many of which would have been familiar to J.M. Keynes himself), for instance:

• if the interest rate cut and fiscal stimulus reduces investors' and consumers' confidence in the strength of the US economy it could have the reverse effect to that intended.
  
• the current crisis was partially triggered by an epidemic of bad (sub-prime) lending facilitated by low interest rates - so is it really a good idea to fan the flames by sending interest rates even lower?
  

On balance I think it would have been much better to go with a series of smaller reductions, month by month or quarter by quarter, rather than one big splurge. I also think that Fed Chairman Ben Bernanke doesn't really know what he's doing. Having said that, he more opportunity to at least have a go at the right solution than Bank of England Governor Mervyn King, who said today that the UK would just have to "tough it out" come what may. So even if the economy goes completely down the tubes (quite possible, if still unlikely), we won't be cutting rates for quite some time.

Why? Basically because King has a sole remit to keep inflation at a 2% target rate, whereas the Fed is tasked with maintaining a monetary environment conductive to "high and stable employment" as well as low inflation. This means that when times are difficult, Bernanke can (at his discretion) slack off on inflation to boost employment. But King doesn't have that flexibility. And he's worried that oil, gas and food price rises are going to feed through to inflation, which doesn't give the Bank of England any wiggle room on interest rates.

Now, the FT, Economist and many other commentators will tell you that taking risks with inflation is dangerous. They're almost completely wrong. There is very, very little evidence that an inflation rate of (say) 10% is any worse for economic growth or employment than a 2% inflation rate. Now, I say "almost completely wrong" rather than "completely wrong" because at some point, inflation does have big costs - look at Zimbabwe for example, where it's 4,000,000% (or something like that). But that's hyper-inflation, not 'regular' inflation. The idea that we would be taking huge risks with the economy if inflation had to rise to (say) 5% rather than 2% because of temporary price pressures on oil and food, is garbage. Remember that next time you're in the pub with an FT journalist!