Friday, October 24, 2008

Fed Interest Rates Due To Fall Again

In what is likely to be another feeble attempt to stimulate the economy the Fed is expected to lower the Fed funds rate again at the conclusion of their next meeting on October 29. The Fed last lowered the funds rate in an emergency session on October 8, but as we can see, it accomplished very little. Right now the Fed funds rate sits at 1.5 percent, and the lowest it has ever been is 1 percent. It was last at that level in 2003 and 2004, and many believed that is what fueled the housing bubble. Investors everywhere are calling for the Fed to cut rates in dramatic fashion. In fact, the Fed funds futures are pricing in a 26 percent chance of the interest rate being cut by 0.75 percent, down to a record low of 0.75 percent according in CNNMoney. Will even a record cut really make a difference, though? Not likely.

The problem is not that rates are too high, the problem is that banks are unwilling to lend money. If banks feel that they have to hoard money in order to avoid disaster, than lowering interest rates will be nothing more than a practice in futility. "It's window dressing, only a psychological weapon," said Sung Won Sohn, economics professor at Cal State University Channel Islands, in a CNNMoney article. "Right now, the problem isn't the cost of the Fed's money, it's that the existing money supply is not circulating. The pipelines are clogged." The Bank of Japan tried this back in the '90s and it didn’t work for them, either. They lowered interest rates all the way down to 0 percent, and to this day their rates are still near that level.

Typically, when the Fed lowers interest rates, people worry about inflation, but with all the pressure on the economy right now inflation is the least of everyone’s worries. The real risk in this action is that when it doesn’t work, people will see that the government has few, if any, options left to fix the crisis. This could potentially send a shockwave through the financial system. "There's a hesitation to do it because it looks like desperation. But they're getting desperate," said, David Wyss chief economist with Standard & Poor's, in a CNNMoney article in response to the proposed Fed funds rate cut.

At this point I think it is a safe bet that we will see some sort of cut to the Fed funds rate by the end of the month--the question is how large it will be. If I had to guess, I would say 0.5 percent. I would be surprised if they went to 0.75 percent, but stranger things have happened. As Wyss, said they are getting desperate.

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