Comments from the Federal Reserve Vice-Chairman Donald Kohn and Chairman Ben Bernanke earlier this week and late last week hinted at the possibility of another interest rate cut at the December 11 Federal Open Market Committee (FOMC) meeting. Rate cuts stimulate the economy and increase investment and consumption, but also provide a risk of inflation. After the FOMC cut the interest rate from 4.75% to 4.5% at the October 31 meeting, few expected the Fed to cut rates again so soon. However, the stimulus provided by the last cut, when the Dow Jones Industrial Average and the Standard and Poor 500 Index rose strongly over several days, were short lived. The housing and financial markets have continued to worsen over the last few weeks, and investors have pulled out of the stock market and reinvested in US Treasury bonds, which has hurt earnings in both markets.

Economists have given mixed criticism on the recent interest rate cuts. One group of critics has said that the Fed has underestimated the recession possibilities posed by the subprime loan and housing crises, while the other group has said that the Fed has lost sight of managing inflation and will have to increase the rate eventually. Both of these fears have manifested themselves, with the Dow going into a full market correction last week, falling 13% over 2 days. Meanwhile, although they have fallen back in recent days, oil prices have approached the $100 per barrel mark. In fact, the White House is predicting the GDP growth to fall from over 3% this year to around 1.5% in 2008.

The Fed needs to address the recent stock and financial market conditions as soon as possible, but another rate cut might not be the right answer. The Fed should maintain the interest rate at its current level at the December 11 meeting to avoid inflation. Historically, recessions have been preceded by a rise in oil prices and the depreciation of the dollar. Both of these indicators have surfaced this year, with oil prices setting record highs and the dollar reaching record lows. Uncontrolled inflation would hurt the US economy greater than a housing market crash can. Although some economists think the housing market downturn will drag the rest of the economy into a recession, this is only speculation with not historical evidence to support it. The Fed should focus its energies on keeping inflation at a manageable level instead of worrying about one ailing market.