Clear and Present Danger

We expect officials to lower the funds rate by a full point to 2% at Tuesday's meeting

The Federal Open Market Committee will convene next week amid continued intense strains in financial markets and signs that economic activity is grinding to a halt. Events bearing on the outlook have worsened substantially since monetary policymakers dropped the funds rate to 3% in late January. The self-feeding downturn now in place shows signs of becoming deeply entrenched, while the ongoing marked deterioration in financial conditions is reinforcing the recessionary dynamic.

Strong consideration ought to be given to an even larger reduction

In this situation, aggressive policy action is warranted and we expect officials to lower the funds rate by a full point to 2% at Tuesday's meeting. Strong consideration ought to be given to an even larger reduction. Such a rate cut coupled with other ongoing policy actions may not be sufficient to stabilize the financial system over even a short horizon. As a result, the accompanying statement likely will higWight policymakers' commitment to pursue a set of policies necessary to secure stability. What is uncertain is whether or not the official communique will detail the various policies under consideration.

Policymakers gradually have signaled their willingness to adopt a more aggressive tack and it is now time to intensify further those efforts. The expansion of T AF, the introduction of the securities lending facility and today' s action to prevent a primary dealer from collapsing are examples of the Fed's more urgent approach to the current crisis.

The financial setting remains on tenterhooks and ongoing instability points to a prolonged adjustment period and uncomfortably elevated probabilities for highly destabilizing outcomes

A functioning financial system is the lifeblood of the U.S. economy and severely challenged market function, clunky intermediation and battered credit market conditions pose a clear and present danger to the economy.

...Bear Steams underscores the current fragility of the system. The Fed has not lent funds in such a capacity for at least several decades and possibly since the Great Depression. The interconnectivity of major financial institutions due to derivatives may have been a contributing factor in the Fed's decision. We cannot be certain, but the spider web of counterparty contracts throughout the financial sector could mean that the failure of one large institution puts the entire system at risk.

Our financial conditions index (FCI) finished February two standard deviations below its norm and has deteriorated considerably further in recent weeks

Our financial conditions index (FCI) provides a framework from which to measure the degree of stress in the broad financial backdrop. The index currently appears to be hovering near minus 2 1/2 sigma, or a level not experienced since the "capital crunch" ofthe early 1990s. Then, as now, the financial sector was saddled with assets that were not performing as anticipated and these problems weighed on the entire economy for an extended period.

While financial conditions as gauged by our index are not yet as restrictive as in that episode, strains in key asset markets are more severe. Dislocations in the mortgage and investment-grade credit markets remain considerable. For instance, the spread between rates on conforming mortgages and the lO-year Treasury still is near its widest level in the past decade, while the cost of buying protection on an index of 125 investment-grade credits has more than doubled so far this year.

Monetary policy cannot be considered to be even remotely close to properly calibrated until strains in the financial system ease

The level of the funds rate -including 0% provides only a partial glimpse of policy's effective stance. Policy is transmitted via the financial system, primarily asset prices, and with actions to date having failed to steady, much less improve, the flnanciallandscape, policy is not positioned to promote moderate growth over time. Until policy is positioned in such a fashion that it first provides a modicum of financial stability and then promotes a more normal set of financial conditions, forecasts of improved economic performance will be just that.

Absent a steadying in the financial backdrop, conditions have the potential to supercharge the increasingly visible self-feeding downturn in the real economy

Consumer spending is slowing quickly. Household demand expanded by a solid 3% plus clip throughout the bulk of expansion but downshifted to 1.9% in the prior quarter and according to this week's retail sales data is inching ahead in Q 1. Core sales were unchanged in February and have increased by a scant 0.2% annualized in the past three months. Real income expectations - spending's primary driver - are fading fast and today's update on this front from the University of Michigan is consistent with an additional deceleration in outlays ahead.

Slowing consumer expenditures will result in a cascade of adverse developments

Weaker spending growth will reduce firms' profit expectations, which in tum will cap businesses' willingness to add to headcount, inventories and the capital stock. The latest canvassing of smaIl firms suggests this process already is under way. Overall optimism has dropped sharply and expansion plans among these firms are probing levels experienced during the past two recessions. At the same time, businesses are not inclined to build inventories, suggesting that the spike in January stockpiles is unlikely to prove durable.

Left unchecked, this toxic background has the potential to fuel a recession unlike any the United States has endured in the past quarter century

The damage already done to the economic outlook is substantial and with the current negative feedback loop putting down deeper and deeper roots by the day, the scope of actions needed to sever this vicious circle is surging.

Continuation of current financial disruptions would usher in a dis inflationary undertow

Ongoing developments also are threat to medium-term price stability. An inflation backdrop that does not distort economic decision making cannot be achieved without financial stability. In this context, while current consumer inflation rates may be higher than many policymakers would prefer, continuation of current financial disruptions would usher in a dis inflationary undertow.