Fed interest rate cut may end up making matters worse

The Federal Open Market Committee’s half-point cut in its Federal Funds target does not address the leverage and credit issues in the banking system.

Indeed, by penalizing savers it worsens the economy’s supply/demand imbalance for funding. The cut doesn’t solve short-term problems and worsens long-term inflation worries.

The banking crisis was not caused by over-high interest rates. Its two main causes were large and unknown housing-related and other credit losses and an urgent need for banks to reduce their leverage.

Those problems are being addressed by huge Fed liquidity doses and plans to directly inject $250bn of new capital into banks via the Troubled Asset Relief Programme. Reducing already low interest rates will have no significant effect in alleviating the causes further.

With the consumer price index up 4.9pc in the last year, savers have been receiving sharply negative real returns. The Fed cut potentially worsens this problem. By cutting to 1pc the US central bank has moved close to its limit; it decided in 2003 that cuts below that rate would be damaging to the money market fund sector, which needs a positive return on short term risk-free paper to pay its expenses.

Such low interest rates discourage saving and encourage borrowing, precisely the reverse of the appropriate prescription for the US economy. Much higher rates, giving savers a real return and bringing supply and demand for funds into equilibrium, are needed in the long term.

The Fed has avoided addressing the significant inflation in the US economy, and now appears to think that problem has solved itself. Yet its rate reductions late last year amplified an unprecedented commodities bubble, which has only been reversed by the current global downturn.

With monetary and fiscal policy both wildly expansionary, there must be some risk of the commodities bubble re-inflating; oil’s 7.6pc rise on October 29 and gold’s recovery from $698 per ounce to $754 in four trading days suggest that possibility is real.

There’s nowhere now for rates to go but up. The sooner the central bank can reverse course, the better.

For more agenda-setting financial insight, visit breakingviews.com

By Martin Hutchinson, breakingviews.com
Last Updated: 1:19PM GMT 30 Oct 2008

Source: The Telegraph

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