Fed Funds Rate Range Slashed to 0-0.25%

The US Federal Reserve yesterday cut the Fed Funds Rate to a range of 0-0.25% from 1%. It can't really go any lower, so that means further cuts, the prime tool used to energize an economy, are no longer available. The Fed can use its balance sheet to buy up mortgage backed securities and bonds from Fannie Mae and Freddie Mac, and it has promised to do this. Nevertheless, America in 2008 is looking a lot like Japan in the 1990s.

As Peter Siris of Guerrilla Partners noted, it doesn't matter what the interest rate is if the bank won't lend. So, this latest rate cut is probably going to translate into more loans only for the most creditworthy, and even then, the amount loaned will be smaller than it might be under other circumstances. This will, in turn, put pressure on bank margins, which will make them even more risk averse. A potentially vicious credit cycle could make the $700 billion bailout a complete waste of money.

This situation is the direct result of the Fed keeping its eye solely on inflation. Its statement of yesterday read in part, “labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further. Meanwhile, inflationary pressures have diminished appreciably.” The central bank isn't even using the right terminology. The last sentence quoted should have read “Meanwhile, deflationary pressures have rising significantly.”

Deflation, the downward spiral of prices, sounds good in theory. Lower food prices, lower energy prices, lower housing prices all sound wonderful, except that they mean less money for farmers, oil workers and the construction trades. Since these workers have less, they can spend less, and demand declines further. Deflation is what caused the Great Depression, not inflation. Of the two, deflation is far harder to fight because the world has less experience of doing so successfully.

Moreover, the Fed focused on the wrong kind of inflation. Inflation to the Fed meant too many people spending too much money on stuff. What was really allowing this was asset inflation: rising housing prices despite increased housing supply; rising stock market values that far exceeded the increased profitability of the listed companies. Asset inflation of recent years allowed the credit bubble to arise in the first place.

One must remember that Japan lost an entire decade of economic growth because of weak demand. Interest rates hit zero and stayed there for years. The government pumped trillions of yen into construction projects and tax cuts. Yet, the Japanese people felt very insecure about their economy and saved rather than spent the money. America faces a similar situation if the government doesn't do something to get people to spend. Thus far, the prospects for doing so are moderate at best.

© 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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