Tuesday, December 16, 2008

Fed funds rate is essentially irrelevant

As I mentioned before the last FOMC meeting, it's really doesn't matter whether the Fed lowers its target for the funds rate today. The target doesn't mean much, in any event, since the actual funds rate has been trading well below its target since mid-September, which is when the Fed effectively shifted its operating procedure away from funds-rate targeting to quantitative easing. They haven't made any official announcement of the shift, so perhaps that will come today.

As this chart shows (assuming they cut the target funds rate to 0.5%), the inflation-adjusted funds rate is as low as it's ever been. Whether or not it drops by 50 bps today is not really that important. Borrowing costs are only onerous for people who are financing things (e.g., energy and commodities) that are falling in price. Most non-energy and non-commodity prices are at least stable or rising. Relative to the rate of core inflation, borrowing costs are negative.

The big thing that the Fed has done is to massively increase the amount of reserves in the banking system. This action alone could potentially dwarf any changes to the funds rate target. As fear of deflation subsides, more and more people will realize that there is very cheap money for the taking, and the process of re-leveraging will begin. This is the important next shoe to drop, not the Fed announcement today.

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