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Tuesday, December 16, 2008

The Consequences of Today's Massive Rate Cuts

Today, the Federal Reserve took more aggressive action to curb the financial crisis by cutting the Federal Funds Rate to .25%.

The Federal Reserve on Tuesday cut its federal funds target rate by more than three-quarters of a percentage point to a range of between 0 and .25 percent. The decision signals that Fed Chief Ben Bernanke is more concerned with the rapidly deteriorating economy--which has been mired in a recession since December of last year--than the prospect of stoking inflation

The implications of this are massive and they are also very difficult to understand. First, here is what the Federal Funds Rate is.

In the United States, the federal funds rate is the interest rate at which private depository institutions (mostly banks) lend balances (federal funds) at the Federal Reserve to other depository institutions, usually overnight.[1] Changing the target rate is one form of open market operations that the Chairman of the Federal Reserve uses to regulate the supply of money in the U.S. economy.[2]

The first thing to know about the Federal Funds Rate is that it is a short term rate. In fact, it is very short term. The Federal Funds Rate is used generally for OVERNIGHT borrowing. In other words, it's a way for financial institutions to raise cash for short term liquidity shortfalls. If someone is in need of Federal Funds, it's usually because they are overextended and need to recapitalize.

First of all, its implication on mortgage rates is difficult to gather. Mortgage rates are long term. After all, you get a mortgage for up to thirty years. The Federal Funds Rate is for very short term borrowing. As such, just because one went down dramatically doesn't mean the other followed suit. In fact, lowering the Federal Funds Rate this dramatically is eventually inflationary and so often the mortgage market reads such rate cuts as long term inflationary and you see the mortgage rates go up. Today, mortgage rates were fairly steady and so this news was inconsequential to the market in the short term.

Second of all, this is meant to stimulate more lending by banks because they can get access more easily to short term money. In my estimation though, what this does is give banks a license to practice in the same risky behavior that got them here. By making it so easy to borrow short term, it gives banks far too much incentive to engage in exactly the sort of behavior that causes them to need funds overnight. When a bank needs to borrow using the Federal Funds, it's almost always to cover some risky behavior.

I believe in many ways that exactly what the Federal Reserve wants. Banks are afraid to lend and the Federal Reserve wants them to throw the proverbial caution to the wind and take a chance on giving credit again. What this will do is give them incentive to take far too much chance. It was the lessening of this very Federal Funds Rate in the early part of this decade, that I believe lead to this mess. Banks took far too much risk and now we are here. They took far too much risk because it was far too easy for them to cover short term liquidity problems. Now, the Fed is making it three quarters of a percent easier than even Alan Greenspan made it back seven years ago.

I believe this rate cut along with much of the government's action lately will create another speculative market somewhere soon enough. That's because in their desire to create stimulus to the economy they are creating far too much of it. All these bailouts, rate cuts, and government intervention isn't just stimulus but far too much stimulus. When the government stimulates too much, that extra stimulus eventually leads to speculation somewhere. That's what Ben Bernanke guaranteed today, and soon enough we will be dealing with the aftermath of the crisis he created today.

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