October 29, 2008

On the Federal Reserve's rate cute

The Federal Reserve's lowering of the Fed Funds target rate to 1% is the latest in a series of moves attempting to keep liquidity flowing in the financial markets. This one, unlike previous moves by the Fed, comes through its main channel. It was completely expected, which explains the stock market's relatively muted response. The Federal Reserve, however, is approaching the bottom of its bag of tricks.

At 1% the Fed Funds target rate is at the lowest it has been since 2003-2004. Because of the huge amount of liquid assets the actual target rate is lower than 1%. If the Fed somehow bottoms out and makes the interest rate reach 0%, they face the same problem that the central bank of Japan faced when it committed similar actions. The Federal Reserve cannot go much lower. It has to resort to alternative measures.

What this means is that the Fed Funds target rate's days as the primary tool of Federal Reserve policy are over. During this crisis alternative tools, like credit swaps, will replace the target rate in primacy. It is unlikely that the target rate will return to prominence except during inflation fighting. Thus, it is very likely that the Federal Reserve has effectively split its tool chest for achieving its two directives of economic growth and controlling inflation: the target rate will be used primarily for the latter now.

This is a welcome change. No longer will interest rates be used in a desperate attempt to boost economic growth at the expense of inflation as it was in the past. We might be seeing the rise of a new era of controlled inflation and economic growth through alternative tools at last.

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