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Monday, October 6, 2008

Is the Fed Attempting To Repeat History?

Today, Forbes published this piece laying out what the Fed did wrong and what the Fed should do going forward.

Looking back to last year, it is clear the Fed's rapid interest-rate cuts were a huge mistake. It was clear that risks to lenders were rising as the economy suffered, but because the Fed drove down short-term interest rates, lenders were forced to take less in income. This undermined lending markets. Why would a bank make a loan in a riskier environment at a lower interest rate?

As a result, credit spreads widened. But for some markets, like those for auction-rate
securities, the market just froze. Investors balked at buying these assets at lower rates. Worse still, the Fed's easy money caused a surge in commodity prices and a doubling in the price of oil.

So, Forbes believes that the rate cuts beginning in September were mistaken. It became a risk to lenders and ballooned gas and food prices. Yet, what does Forbes think the Fed should do?

In other words, the Fed must cut interest rates again. We suggest an immediate cut of 100 basis points, which would push the Federal Funds Rate back to 1% from its current level of 2%. Cutting by 25 or even 50 basis points at a time would leave the market wanting more, so we suggest some shock and awe from the Fed. After all, other short-term market rates are already down at this lower level.

So, in other words, even though Forbes believes prior significant rate cuts failed miserably, Forbes then believes that the Fed should cut rates even more. Now, if this circular logic doesn't really make sense, then think about this. In my opinion, the Federal Reserve's significant rate cuts started the ball rolling on the mortgage crisis. By lowering the Fed Funds Rate below 1%, it created so called "loose" money and that got the ball rolling on irresponsible lending? At the time, the Fed Funds Rate was .75%. Forbes wants the Fed to now lower rate to 1%.

So, why would Forbes be recommending that the Fed do the exact same thing now seven years later? That, I don't know. Forbes is a business magazine though and they can't force Fed action. So, what is the Fed thinking? According to CNBC, there are rumors that the Fed is thinking about doing what Forbes suggests. It appears that the Fed may not only not be learning from really recent history and also recent history as well. Significant rate cuts didn't work in 2001-2002. They didn't work last year. Yet, the Fed seems determined to see if third times the charm.

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