The Fed caught many people by surprise last week when it cut rates by a half percentage point. Apparently, the increasing evidence of economic weakness was sufficient to prompt the Fed to move aggressively. Predictably, the stock market rallied in response to this rate cut. As Bruce Steinberg, chief economist at Merrill Lynch said, there's a simple message, the Fed will do whatever it takes to keep the U.S. economy from going down the tubes.'' The financial markets are evidently convinced that the Fed will be able to prevent a recession.

This confidence in the Fed may be misplaced. That quote was a reaction to Fed’s half point rate cut at the beginning of January in 2001, when the economy was also threatened with a recession due to a collapsing financial bubble. At that time the collapse was in the stock market. By the beginning of 2001, the Nasdaq was down by more than 40 percent from its peak in March of 2000 and the broader S&P 500 index was down by almost 15 percent. Investment was already stumbling and job growth had slowed to a trickle.

This was the context in which Greenspan rushed to the helm with a half percentage point rate cut, agreed to at an emergency meeting in the first days of the new year. The markets were impressed. The Dow rose by 2.8 percent and the Nasdaq jumped by an incredible 14.2 percent in a single day.

But the euphoria didn’t last. Less than two months later the economy began shedding jobs and had officially entered a recession. The job loss continued through the middle of 2003. The economy didn’t start adding jobs at decent pace until the middle of the 2004, and the jobs numbers didn’t pass their pre-recession peak until February of 2005, almost four full years from the onset of the recession.

This downturn took place in spite of Greenspan’s aggressive rate cutting strategy. By the summer of 2001, Greenspan had lowered the federal funds rate a full three percentage points to 3.5 percent. He dropped rates even lower in the wake of the September 11th attacks, reaching 1.75 percent by the end of the year. Further rate cuts over the next year and a half brought the rate to 1.0 percent by the summer of 2003, a fifty year low.

However, five and half percentage points of rate cuts were not sufficient to stave off recession in the wake of the stock market crash. In fact, Greenspan found it necessary to lash on to the housing bubble as the only source of strength in an otherwise moribund economy.

With this backdrop, it looks like the market surge following Bernanke’s surprise half point cut was another overreaction. At the margin, the rate cut will help some businesses and consumers make ends meet, but it will not reverse the momentum of a collapsing housing bubble. In the spring, house prices were already falling at single digit rates in markets like New York, Washington, Boston, and Los Angeles. They were dropping at double digit rates in what had been superheated markets: cities like San Diego, Miami, Phoenix, and Las Vegas.

These declines were recorded before the impact of any freeze-ups in the mortgage market. Now that the world assigns real risk to mortgage lending in the United States, does anyone think that a half percentage point cut in the federal funds rate will be sufficient to reverse the drop in housing prices? Will it cause lenders to rush mortgage money into housing markets where prices are dropping at double-digit rates?

At this point there is little that the Fed can (or should) do to stave off the collapse of the housing bubble. This collapse will almost certainly throw the economy into another recession. The housing sector itself is likely to contract another 20 to 40 percent from current levels, chopping 1-2 percentage points off GDP growth. Even more important, falling house prices will quickly bring the home equity fueled consumption binge to an end. If house prices return to trend, it will eliminate more than $8 trillion of housing bubble wealth, which will hugely impact consumption.

In short, once the housing bubble starts to collapse, a recession is pretty much a done deal. Bernanke is doing the right thing in lowering rates, but he will not be as aggressive a rate cutter as Greenspan, and even Greenspan’s cuts were not sufficient to prevent a recession. It will take more than Fed rate cuts to get the economy back on a path towards healthy, non-bubble driven growth.