The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets.
The Committee expects inflation to moderate in coming quarters, but it will be necessary to continue to monitor inflation developments carefully.
Appreciable downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.
Willem Buiter slammed the move:
In yesterday's Financial Times - before the latest bout of financial market freak out - Wolfgang Munchau looked at the channels through which monetary policy affects the economy and concluded that it is unlikely to be effective in the current situation:
It is bad news when the markets panic. It is worse news when one of the world's key monetary policy making institutions panics....This extraordinary action was excessive and smells of fear. It is the clearest example of monetary policy panic football I have witnessed in more than thirty years as a professional economist. Because the action is so disproportionate, it is likely to further unsettle markets.
It would therefore be unwise, to say the least, for policymakers to rely on monetary policy alone. By far the best policy response – though clearly limited in scope – is a well-targeted fiscal policy stimulus...
The best stimulus package would be one that could be agreed today, enacted tomorrow, targeted specifically at subprime families, and was only temporary. Back in the real world, where politicians run fiscal policy, this is obviously not going to happen. While the usual pork-barrel-type stimulus package that is now shaping up in the US is far from ideal, it is still marginally better than letting the central bank sort out this mess alone.
There is no such thing as a standard policy response to all recessions. There are recessions like the one in 2001, which respond well to a monetary policy stimulus. But not all do. This is going to be one of those.
Although the Keynesian model, as we teach it to our students, allows for both fiscal and monetary policy effects, the traditional Keynesian argument is that monetary policy is like a string - it can be easily pulled to slow down an "overheating" economy, but not effectively "pushed" to stimulate it. That is particularly true in the case of a "liquidity trap," which Paul Krugman believes Bernanke is trying to avoid:
What you probably should know is that Ben Bernanke, in his capacity as a professional economist, spent a lot of time worrying about Japan’s experience in the 1990s. (So did I.) What was so disturbing about Japan was the way monetary policy became ineffective; by the later 1990s the short-term interest rate was up against the ZLB — the “zero lower bound.” This is alternatively known as the “liquidity trap.” And once you’re there, conventional monetary policy can do no more, because interest rates can’t go below zero.Update: The Economist's Free Exchange has a roundup of reactions to the Fed's move.
There was a lot of discussion of various unconventional monetary things you could do. But the best answer was not to get there in the first place. A 2004 paper co-authored by Bernanke argued that the ZLB could and should be avoided by “maintaining a sufficient inflation buffer and easing preemptively as necessary”.
And here we go.
Update #2: Stephen Cecchetti thinks Bernanke is the new sheriff in town.