Prudent

17 September 2008



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Fed Holds Interest Rates Stable

The Federal Reserve chose to leave American interest rates unchanged, with the fed funds rate at 2%. The financial industry had hoped for a cut to pump money into the system and halt the pain of Lehman’s collapse. The Fed, however, did the right thing in holding off.

At 2%, the current set up is adequate for economic recovery, and the Fed doesn’t want to be in a position where it is getting close to 0% without any sign of improvement. The last thing the US needs is to relive Japan’s 1990s.

Besides, the worry isn’t that there isn’t any money to lend. The trouble is the banks unwillingness to issue any loans. Bloomberg reports, “The London interbank offered rate, or Libor, that financial institutions charge each other to borrow soared 3.33 percentage points to 6.44 percent today, its biggest jump in at least seven years, according to the British Bankers' Association. The rate was as low as 2.07 percent in June. Banks are driving up short-term lending rates on concern that AIG, the biggest U.S. insurer, will follow Lehman into bankruptcy and leave financial institutions with losses on $441 billion of credit derivatives. Central banks around the world pumped more than $210 billion into the financial system as they sought to alleviate the credit-market seizure.”

Sadly, this is one of those times when doing nothing is the best option. AIG failed, and who knows if there isn’t another major bank (this time a retail institution) on the edge. The market’s current attitude is one of blind terror, and any news is going to be viewed through that prism. It’s probably best to let the next batch of bad news hit before doing much to the system.

Moreover, there is something to be said for retaining the ability to surprise the markets. If there is more bad news out there, it would be better for the Fed to simply announce one Thursday morning that it was changing rates, at a time when no one was expecting it. Markets always behave better when they haven’t factored everything in.

© Copyright 2008 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Fedora Linux.

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