I don't know whether the spreading damage from the subprime mortgage debacle will get anywhere bad enough to push the economy into recession. I doubt it, though. Today's data on consumer spending—sales rose 0.3 percent, core sales 0.5 percent—were encouraging, and many economists now think that the second-quarter gross domestic product number will be revised to perhaps as high as 4 percent from 3.4 percent.
So the "real economy" still looks pretty good even as the "financial economy"—Wall Street—looks a bit shaky right now. And don't forget that the global economy is booming. The International Monetary Fund recently raised its 2007 global GDP forecast to 5.2 percent. (It's not an overstatement to say that we are witnessing the greatest global economy in the history of mankind.)
But the Federal Reserve shouldn't make policy based only on likely economic outcomes. It also needs to take into account minimizing the chances of highly negative outcomes. A recession not only would cost people jobs—that's bad enough—but it might give further momentum to the economic populists in Congress who desire to punish China for the U.S. trade deficit and also want to raise taxes to combat perceived growing income inequality.
Those are exactly the sort of policy mistakes that could undercut productivity growth and reduce the potential top speed that the American economy can grow at without sparking inflationary pressure. Already there is growing pressure for government to "do something" to help borrowers and lenders. As a recent note from Goldman Sachs put it:
"Market participants have begun to focus on the potential for government intervention in the mortgage market for the second time this year. Political intervention has appeared likely only if the housing and mortgage market deteriorated further, and recent developments appear to have given politicians new motivation. While political pressure to "rescue" lenders and borrowers is likely to increase further and some changes are clearly possible, market expectations for relief are already high and some level of resistance from the Bush administration and Republicans in Congress is likely."
While I don't think the Fed needs to have an emergency meeting, a cut at the next meeting or two (or three) might be a nice low-cost insurance policy. Neither the bond market nor government statistics give much indication that inflation risks need to outweigh risks to growth in Fed thinking. Yes, yes, I know high gold prices are seen as a powerful inflation indicator by some. But I don't think there is much risk of the Fed either sparking inflation or unanchoring inflation expectations. As my good friend Paul Hoffmeister of Bretton Woods Research notes:
"We believe any immediate questioning of the Fed's inflation vigilance because of a rate cut would be short-lived because a resuscitation in economic growth at the margin should support the dollar over the long term, because economic growth is a deflationary force as new productive enterprise absorbs excess liquidity."
One of my cardinal rules: Growth solves a lot of problems.