Monday, September 15, 2008

It doesn't matter whether the Fed cuts rates tomorrow

Futures markets are suggesting a strong probability that the Fed will announce another cut in its target for the Federal funds rate tomorrow, which would bring it down from 2.0% to 1.75%. Presumably they would do this in order to provide support to the economy at a time when financial markets are in distress. I don't think it really matters whether they cut or not. For one, rates are already very low relative to inflation (see chart). Monetary policy is already about as easy as it gets. Second, I don't believe that reducing interest rates makes the economy stronger. If anything, it might exacerbate the inflationary problems which have contributed to get us in this mess in the first place. The seeds of the housing bubble were sown back in the early 2000s, when the Fed held short-term rates very low for an extended period. This encouraged financial players to use too much leverage, and it encouraged builders to build too many homes, and it encouraged buyers to bid prices up too high. Eventually this bubble had to burst.

The only way that the Fed could take direct action to solve the housing problem (which is now essentially a problem of falling prices), is to pump so much money into the economy that it lifts all prices. Like a rising tide that lifts all boats, a massive infusion of money would lift all prices. Housing prices might stop falling as other prices, including incomes, rose. Housing could quickly become more affordable, and inflationary policies would once again heat up the demand for physical things, since those are what hold their value during times of inflation.

A cut of 0.25% in the funds rate is not going to be the key to unlocking a flood of new money. But it could weaken demand for dollars (since easy money undermines the long-term value of a currency), and that would be a lot worse than any amount of stimulus that lower rates might imply. Don't forget also that the Fed can only control short-term interest rates; the rest of the yield curve is determined by the market.

If I were Bernanke, I would not want to cut rates tomorrow. I would want to signal to the market that my next move would be to raise rates, because I'm more concerned about inflation and the value of the dollar than I am about the solvency of some investment banks.

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