Fed Watch: Where Is The Rate Cut?

Tim Duy says the Fed may not cut the target interest rate at its next rate setting meeting:

Where Is The Rate Cut?, by Tim Duy: On the surface, the case for a rate cut seems obvious. But, despite an extraordinary and historic two weeks on Wall Street, Bernanke & Co. have failed to deliver. And perhaps the lack of action today, a day of panic in global equity markets, is telling us something about policy – don’t look for a rate cut, at least not yet. Maybe we should be listening.

If there is one thing the Fed has taught us in the last year, it is that they are inclined to meet periods of financial turbulence with a rate cut. Hence growing expectation for a rate cut, expectations that were only heightened by the string of data that confirmed for almost all remaining doubters that the US economy had slid into recession by at least the third quarter, if not much earlier. Last week’s employment and ISM reports for September appeared to seal the deal on that call.

Relatively dovish Fed-speak appeared to confirm these expectations. And if a rate cut was coming, why wait until the end of the month, especially when equity markets needed a boost of confidence? Yet no rate cut emerged. Instead, some Fed speakers have come out against a rate cut, such as St. Louis Fed President James Bullard and Richmond Fed President Jeffrey Lacker. To be sure, perhaps they are simply out of step with the Board. But perhaps the Fed has come to the conclusion that, at least for now, interest rates are not the problem, especially since, relative to the rate of decline in the real economy, the Fed is well ahead of where it would normally be at this point in the cycle.

It is arguable that rate cuts have done little to stem the tide of deleveraging that is ravaging the banking system. Indeed, despite a policy path that appears determined not to remake the Fed’s mistake during the 1930’s by taking rates down quickly and flooding the financial markets with liquidity, the crisis continues unabated, as if the more the Fed does, the more financial markets need done. To be sure, perhaps the situation would be worse if not for the Fed’s actions, but those actions failed to produce anything remotely near the quick fix I think was originally envisioned by Fed Chairman Ben Bernanke. Some even think the Fed is making the situation worse via their liquidity provisions, prolonging the lack of interbank lending by providing an escape valve. Why try to reduce counterparty risk when the Fed stands ready to be the riskless partner?

The lack of a rate cut at this juncture suggests the Fed is readying a new bag of tricks. They let us sneak a peek at that bag today, using the new powers granted by TARP to pay interest on deposits, thereby setting a lower bound on the Fed Funds rate that should nearly reduce the Fed’s need to sterilize their liquidity provisions via term auction facilities. At the same time, they extended the size of the TAF. These are clear efforts to fix broken credit channels, and this is likely the Fed’s focus, not interest rates.

But, as noted above, will an expansion of the existing liquidity provisions, or additional rate cuts, have any impact? Or are they simply more of already failed policies? The Fed is likely preparing for a significant new initiative, consistent with reports that the Fed, with the cooperation of Treasury, is preparing a program to purchase a broader class of assets than simply troubled mortgage backed securities. Outright purchases of commercial paper appears to be on the table – not surprising as the growing credit crunch in this market threatens working capital, the lifeblood of daily commerce.

Would outright purchases be inflationary? Here is where the Fed would believe that the ability to pay interest on deposits is important – short term interest rates cannot fall much below the Fed Funds rate, as any excess money would simply flow into reserves at the Fed. The ability to pay deposits should automatically sterilize any excess money creation. This might also explain why the Fed would be hesitant to cut rates at this point; policymakers would want to see if the new system worked as expected before changing policy rates. We are in uncharted territory here, but if excess money created simply flows automatically back into the Fed’s coffers, inflation should not be a concern (assuming that outright purchases are equivalent to term lending). If credit channels suddenly loosen up, then interest rates may prove to be too low and inflationary, but the Fed hopefully, could react quickly by raising the Fed Funds rate and the interest rates they pay depositors.

Bottom Line: It is impossible to rule out a rate cut, and it seems like a cut should be the baseline case. Indeed, the case for a rate cut should be a slam dunk, expect for a.) rates are already low and b.) we haven’t seen a rate cut yet. The latter point, especially given the intensity of the crisis over the last two weeks, suggests that looking for a rate cut is simply a case of barking up the wrong tree. It is what we have been conditioned to look for, and hence we are expecting it. But there is nothing like an inconvenient fact to undermine a perfectly good theory. The Fed may simply have already moved well beyond rate cuts in searching for solutions to the current crisis. And outright asset purchases is looking like that next move.

Comments

[a]

"And if a rate cut was coming, why wait until the end of the month, especially when equity markets needed a boost of confidence?"

This is perfect example how the U.S. economy has been mismanaged for the past 20 years. It is not, cannot, and should not, be the job of the Fed to boost confidence in the equity market.

[hari]

Global IMF/IBRD meeting on 10 Oct and there is likely to be a coordinated action by Fed/ECB and other CBs to cut rate. I warned about inflation before, but that will not be a priority at this juncture of a global recession and more.
This is a more serious financial crisis than anticipated by Europeans, in particular. The contagion is sucking credit and lending is almost at stadstill - this can't be a good sign.

[acerimusdux]

Well, if Treasury is pumping some of these new funds into commercial paper, it won't be as bad. But if they are using this $700B to buy MBS, and financing that with new debt (not cutting rates), that would just be drawing that $700B out of these same stressed short term lending markets.

Normal monetary policy would be exchanging dollars for US Treasury debt. Is the "bailout" actually an alternative to this, exchanging dollars for corporate debt instead?

[kharris]

Fisher, in yesterday's Q&A, seemed pretty obviously to have changed his view about the advisability of an ease. He is more worried about growth, less about inflation. However, he has doubts about the effectiveness of an ease with credit markets impaired. As the champion of the hawks, Fisher makes a pretty good source of information about the likelihood of an ease - playing against type. His comment was overt, but fit pretty well with more oblique comments from other Fed officials. They are probably gonna ease, but they may be reluctant to use up the headline impact of a bunch of basis points only to see credit markets stay stuck. The CP thingie may pave the way for an ease.

[Murph]

Mark - does Tim Duy have a 'home' site where other of his thoughts are posted ?

[Long Run/Short Run]

In the long run: Rates are already negative, discouraging domestic saving in a form that can be loaned out. We don't need negative real rates, we need stable credit supply to credit worthy businesses/consumers. Encourage domestic savers to save in a form that can be loaned out (positive interest rates/assurance that they will get their purchasing power returned to them when they need it). Enough with depending exclusively upon volatile foreign savings. Build up more stable domestic savings like other nations do.

In the short run, solvency is the immediate problem. The system is filled with loans that will not be paid back, making foreign savers panic. The foreign money that was once in abundance has fled elsewhere. Foreigners will no longer extend very many private loans. Since we don't have a stable base of domestic deposits, this effectively shuts down most private loans. FDIC style coverage will have to be extended to foreign loans until domestic savings can be built up. Since there are finite resources available to to this, business loans and sensible consumer loans will have to be prioritized. We simply don't have the resources to support ever expanding bubble prices, and still keep credit flowing to essential areas.

[bakho]

Won't lending still be frozen no matter how many basis points are cut?

[Basis Points]

The idea behind cutting basis points is to extract forced savings from inflation vulnerable entities, and transfer the purchasing power to banks. Basically, a regressive tax that is given to the banking system, instead of the public. The theory is that this extra purchasing power will strengthen banks, and they will eventually be able to loan more.

Unfortunately, in addition to directly harming inflation vulnerable entities, forced savings has serious side effects, which can cause or magnify problems. We are experiencing some of the side effects now.

[James Kroeger]

Encourage domestic savers to save in a form that can be loaned out...Build up more stable domestic savings like other nations do.This is an irrelevant point. It is based on the spurious assumption that the quantity of loanable funds that banks have is dependent on the savings of households. Not a shred of truth to it.

Any time the Fed determines that banks have insufficient loanable reserves to keep interest rates at the level they desire, they purchase Treasuries with money that they bring into existence for the first time with a keystroke. None of the dollars that are used for these purchases is debited from some account of limited size. The purchases inject loanable reserves into banks that were not saved by any saver.

It has always been wrong to characterize the Supply of Loanable Funds as dependent in any way on savings. The Fed's power to determine interest rates is absolute because it has absolute control of money supply. If the Fed is not currently injecting loanable reserves into commercial banks through this method, it is because it is trying to achieve some other goal.

Encouraging more savings (= NOT spending) at a time when aggregate demand is threatening to collapse is insane. We need MORE SPENDING, not less. The current situation calls for a big tax increase on the savings of the wealthy in order to finance the bailout that only they will really benefit from.

[Long Run/Short Run]

"The current situation calls for a big tax increase on the savings of the wealthy in order to finance the bailout that only they will really benefit from."

The problem is that creating additional money does not tax the rich, it taxes the bottom 90%. This reduces the purchasing power of the very people who are being asked to spend more. A tax on the rich would be a progressive income tax, or a hefty inheritance tax on large estates. Under our system, inflation taxes the bottom 90%, which is self defeating with regard to increasing demand.

[Winslow R.]

"Outright purchases of commercial paper appears to be on the table – not surprising as the growing credit crunch in this market threatens working capital, the lifeblood of daily commerce. "

Now that the Fed has opened the window to corporations, something that can be created for $700, one has to wonder when they will open the window to citizens who cost some $250,000?

What are the details? Can I or any citizen open up a corporation and issue bonds in unlimited quantities and be held unaccountable if I default?

How does the Fed pick which corporate debt it is willing to purchase?

I've given up on Ben.

[obey]

I don't understand the rationale for a rate cut when the Fed already can't meet their current target. The fed is currently auctioning off money at well above their current target rate. The expansion of the funds being auctioned will help in that direction, but a rate cut at this point seems irrelevant.

[Long Run/Short Run]

"Any time the Fed determines that banks have insufficient loanable reserves to keep interest rates at the level they desire, they purchase Treasuries with money that they bring into existence for the first time with a keystroke. None of the dollars that are used for these purchases is debited from some account of limited size."

Short rates only. Long rates are dependent upon savings. Short rates can be influenced this way because the money supply is only about 1 trillion. Long term debt is many times as large. Printing enough extra money to manage long rates causes Zimbabwe style inflation. As it is, managing short rates via forced savings has been contributing to a declining standard of living for the bottom 90%. Forced savings is not free. It is a very expensive and regressive way to raise funds for operations.

A better way would be a progressive income tax on the rich, the proceeds of which is used to loan out at low short rates. That way you are not taking purchasing power away from the bottom 90% to fund operations.

[Winslow R.]

"The problem is that creating additional money does not tax the rich, it taxes the bottom 90%. This reduces the purchasing power of the very people who are being asked to spend more. A tax on the rich would be a progressive income tax, or a hefty inheritance tax on large estates. Under our system, inflation taxes the bottom 90%, which is self defeating with regard to increasing demand."

All depends how that 'additional' money is distributed.

The 'additional' money is being distributed to the financial sector, and now corporations.

The only economically 'just' way for distribution is to give everyone equal access based on citizenship.

The current monetary/fiscal mechanism is a fine tuned extraction mechanism moving wealth from those at the bottom to those at the top.

It doesn't have to be that way.

[Winslow R.]

"Short rates only. Long rates are dependent upon savings. Short rates can be influenced this way because the money supply is only about 1 trillion."

Not true, the Fed is already moving from overnight into longer term loans (more than 3 months)

"Long term debt is many times as large. Printing enough extra money to manage long rates causes Zimbabwe style inflation."

Yes, long-term debt is many times as large through leverage.
Wrong, lending enough extra money to manage long rates just shifts interest income from the financial sector to the Fed.

[Winslow R.]

The Fed is becoming an 'interest farmer' just as the IRS is a 'tax farmer'.

I don't see why either should be 'privatized' as it just leads to private profits and socialized losses. A very inefficient system as the Romans discovered.

says...

"How does the Fed pick which corporate debt it is willing to purchase?"

Simple, it just calls over to Bill Gross and asks him what he wants to sell that day.

[esb]

After the shock wears off in a day or so (or perhaps even later today) the markets will vote again on this nonsense.

The vote will be nay.

Bernanke has tossed so many balls into the air simultaneously that they are interacting with each other in some wild sort of carem game in which no ball ever can come down anywhere near the point desired by the player.

[Long Run/Short Run]

"All depends how that 'additional' money is distributed."

Yes, this is true. If new money were distributed evenly, everyone's purchasing power would remain the same as it was before the extra money was created. (In which case, why bother creating extra money, just let prices fall as more is produced due to technological advancements. All consumers would be able to buy more.)

"The current monetary/fiscal mechanism is a fine tuned extraction mechanism moving wealth from those at the bottom to those at the top.

It doesn't have to be that way."

Yes, I agree.

[Patrick]

A rate cut would probably be a wasted effort. At this point, any new liquidity will just be hoarded.

They aren't addressing the transparency issue. The only way this gets resolved is if all the financial firms lift they veil so everyone knows what they are on the hook for. They need to do as Prof. Roubini has suggested and start a triage process to reveal who is on the hook for what, thus who is hopelessly insolvent and who is just illiquid, and thus who is going to be liquidated and who is not.

The failure to do this is being taken as a signal that everyone is insolvent, and given the size of the CDS problem it wouldn't surprise me if this was the case... Happy thoughts... happy thoughts

[Winslow R.]

" (In which case, why bother creating extra money, just let prices fall as more is produced due to technological advancements."

Prices may fall but debt doesn't except through bankruptcy.

Why not let debt fall?

Because deleveraging causes huge disruptions to the real economy as even very productive members of society are forced to take time to muddle through bankruptcy. Even when the emerge, they are damaged goods for no reason except they mistimed a 60 year credit cycle which shouldn't even exist.

Not a good reason to keep current people from producing real wealth for the future benefit of our children so they too can pay taxes :)

[James Kroeger]

Short rates only. Long rates are dependent upon savings.Why do I keep hearing people say this?

Is the Fed specifically prohibited by Congress from buying 10-year Treasuries?

Is the Fed prohibited by Congress from buying mortgages?

Is the Fed prohibited by Congress from buying real equity in privately-owned corporations?

Apparently not.

Is the Fed prohibited from issuing Federal Reserve Bonds (notes?) with 10-, 15-, or 20-yr. maturities, that would serve the same function as China's 'sterilization bonds?'

I don't believe the Fed has such restrictions.

I would love to be presented with some verifiable 'facts' that prove my assertions wrong...

[Winslow R.]

"Printing enough extra money to manage long rates causes Zimbabwe style inflation."

Zimbabwe doesn't 'sterilize' government spending by issuing soverign bonds (monetary policy). Zimbabwe also lacks an efficient taxing mechanism (fiscal policy).

[James Kroeger]

A better way would be a progressive income tax on the rich...I couldn't agree with you more; but then...you are calling for increased savings, aren't you? I make the assumption that if you increase the progressivity of the income tax, especially among the top 5%-10% of all income earners, the government would be collecting a great deal of money that would otherwise have been saved. Can you reconcile this?

[Bruce Wilder]

Who needs a rate cut, when the Fed is willing, for a modest fee, to take unsecured commercial paper?

[vorpal]

Long Run Short Run has a firm grasp on the current economic situation. Rates need to go up. Personal saving needs to increase to over 10%, that will only happen with higher interest rates.

We have to do the one thing that we least want to do. In theory, that's why we have economic theory. Otherwise, we would just do what seemed best and get the right results.

[Anona]

James K.: The Fed's power to determine interest rates is absolute because it has absolute control of money supply.

A quarter of a century ago, you would have been right. But the whole problem right now is that by allowing the growth of money market funds/commercial paper market, the Fed gave up control of the money supply via the banking system. As long as money markets were stable this didn't matter, but now the Fed finds itself forced to create a whole new central banking model on the fly.

In short, it's not just the banks that have loanable funds these days, it's the money market funds -- and they've just been instructed by their depositors to transfer a big chunk of their funds from the corporate sector to Treasuries.

[Gegner]

If you throw a dog a bone every time it barks, you end up with a fat dog that barks alot. The Fed rate was not 'high' when they started cutting, and the resultant cuts have done little to improve economic dynamics.

The punditry keeps selling the idea that there isn't enough money to lend when the real crisis lies in 'creditworthiness'. There are too few (sound/solvent) borrowers to keep our debt driven system afloat.

[BJ Feng]

I hope the FED understands this is what happens during deleveraging. Markets go lower and commodity prices fall as people reduce their exposure and pay back borrowed funds. There is no way to avoid this pain, and it is necessary so that we can get back to more reasonable levels of credit.

I seriously hope the FED does not repeat the mistakes of Greenspan, that is to reflate and inflate any declines away by expanding credit. Well this monetary policy temporarily "solves" the problem, but fuels new bubbles elsewhere, total credit cannot continue to expand at the rate is has over the past decade. This is sort of like wildfire management. We now know that wildfires cannot be eliminated completely. We can try our best and we may succeed for a number of years, but what we're really doing is sowing the seed for an even larger fire. All the dead brush and vegetation has to be recycled and cleared by natural fires, if you try to stop fires from occurring, the pressure builds until it can no longer be contained. Instead of a fire that will not destroy the largest trees, you have a huge fire that burns down everything.

The financial system is similar. The fallacy here is that we can, or SHOULD stop routine troubles. The business cycle is alive and well, we can't prevent downturns, they are natural and needed to eliminate inefficient firms and pave the path for new growth. The dead brush has to be cleared so that new vegetation can sprout and grow.

Unfortunately, that means we have to ignore the unwise and reckless demands of the left. Anytime the economy shows even the hint of a slowdown, leftists scream and whine for government intervention to stop the decline. More rate cuts and more government spending. Well the FED can inflate the problem away by easing credit and lowering the FED Funds rate, but that only temporarily solves any problems. If there is a bubble, then the FED has to pop it while it is manageable, and allow us to experience the necessary "pain" that comes from deflating credit. The leftist tirades that will follow must be ignored, whoever is in charge must bear the unfair criticism and unfounded charges that will follow. We all know that the president has very little control over the economy. He has no control over the budget other than the threat of veto, and he does not control monetary policy which is set by an independent FED, who answers to Congress. Congress is not responsible for the amount of credit available in the marketplace, the FED was made independent so that it could be sheltered from politics. Politicians have to ignore the wackos, they should not transfer political pressure to the FED. We need periodic bouts of pain and financial crises cannot be avoided regardless of regulations. The only sure thing is that we will have another crisis in the future no matter what new and lauded regulations are passed, the only question is if those regulations will make the future crisis worse than it has to be.

[hari]

Bernake speaking today to Business Economic Club said there is good chance that inflation will moderate down the line...he left the possibility of rate cut next meeting.

[Mark will surely bring it up as soon as he can get it.]

[Long Run/Short Run]

"Zimbabwe doesn't 'sterilize' government spending by issuing sovereign bonds..."

Its not the fact that we issue bonds that prevents inflation, it is the fact that the bonds are sold overseas. Issuing sovereign bonds is just another way of saying we borrow resources from overseas. That is, we don't print very much for public spending, we borrow most of it from overseas. Zimbabwe tries to fund most public spending via monetary creation, while we fund only a small part of public spending via monetary creation (the Fed buys a small fraction of outstanding treasury bills). If Zimbabwe could issue sovereign bonds to fund public spending, and sell them to China, inflation would stop. If Zimbabwe created enough new money to buy all of the sovereign bonds it issued, hyper inflation would continue as now.

The Fed creates new money, and buys a limited number of treasuries (forced savings). That is why we have mild inflation rather than mild deflation. The Fed tried to control long rates a few decades ago, and it led to stagflation. So much money had to be created to keep long rates down that inflation got out of control. Thus the modern policy of a de facto limit to controlling short rates. Long public/private bonds are generally bought by overseas entities.

If the Fed attempted to create enough new money to buy all domestic public/private long bonds, hyper inflation would result. They are currently buying a small number of longer maturity bonds, but they are doing so with resources the Treasury borrowed from overseas, and temporarily transferred to the Fed.

[calmo]

Gegner, you figure it's Joe's (the next VP's) pal that can only afford to fill his tank up to half that is not getting his loan so he can fill it right to the top...or izit about some bigger gas tanks?

[don]

bj feng
I agree.
Not a word in any of the above about the problem of continuing the imbalance of U.S. net borrowing. Just ways to move the borrowing from the chastised U.S. consumer to the federal government so that the party can continue. As a result, the next crisis will be the treasury's insolvency. But wait. That's unfair. This is a just a special case, for the short run. We need to keep up the borrowing to prevent a downturn. Then, we promise, we will staighten up our balance sheets. We will raise taxes by enough not only to pay for our current entitlement overhang, but to fund universal health care.
Right.
It's just a good thing that much of our national debt is funded by currency mercantilists who show no signs of ever wanting to be repaid for their loans.

[esb]

Its too late for that, kiddo.

Its also too late for the Paulson ploy and the Bernanke facilities tapdance.

Its almost too late for a partial nationalization to work.

Meanwhile Bernanke just keeps sliding his curves up and down and all around his "log" charts, like a bum in a restaurant trying to make bills appear in his wallet by doodling on a napkin.

[Patrick]

don

"universal health"

Interesting hobby horse you got there.

What about $2 trillion for Iraq? That OK?

[Winslow R.]

Long run wrote: " If Zimbabwe created enough new money to buy all of the sovereign bonds it issued, hyper inflation would continue as now."

Stop and think, please.

Zimbabwe would create the sovereign bonds as the U.S. creates Treasury bonds.

Zimbabwe then sells the bonds to the public receiving cash in exchange. This is how cash is pulled from the economy slowing inflation.

"If the Fed attempted to create enough new money to buy all domestic public/private long bonds, hyper inflation would result. They are currently buying a small number of longer maturity bonds"

This is correct and would lower short-term interest rates to zero. Hence the new rule that allows the Fed to pay interest on reserves. The rule is a short-term interest rate support mechanism in the face of a massive supply of new reserves.

"but they are doing so with resources the Treasury borrowed from overseas, and temporarily transferred to the Fed."

Totally wrong. Keep working at it :)

[don]

Patrick
I think we agree on Iraq, at least.

[kthomas]

calmo is BACK! Right on, brother! We (especially paine and I) really missed your posts.

[kthomas]

BJ! Once again you write elequently up to a point...",,,Unfortunately, that means we have to ignore the unwise and reckless demands of the left. Anytime the economy shows even the hint of a slowdown, leftists scream and whine for government intervention to stop the decline."

It aint just leftists screming and whining, amigo, not now, not with this mess made by Big Government Republicans. Make sure you understand that.

[Sandman]

The "demands" of the left is a lie. The fact is everytime the captialism goes into crisis, somebody asks for something. After the 1870's-90's crisis, the capitalist class has ASKED for government intervention to support them. Considering the rise of alternates to capitalism that occured during that era, no wonder why. Its impacts were felt brutally in the 20th century. Basically somebody like Bernanke is trying to hold the dummy's hand down the stairs. Cept he just fell over and wounded his knee, down the stairs we go.

Feng is intellectualizing rather realizing.

[Barkley Rosserr]

Over on econbrowser somebody pointed out that the interbank rate has been below the fed funds rate at 1.3%. So, a 50 bp cut of the target ffr would do a big fat zero right now.

[acerimusdux]

Long Run/Short Run says...

"The problem is that creating additional money does not tax the rich, it taxes the bottom 90%. This reduces the purchasing power of the very people who are being asked to spend more."

It is effectively a tax on wealth, thus it mostly taxes the wealthy. Incomes will generally increase with inflation (if the source is truly monetary). I fail to see where the top 10% are finding loopholes to get out of inflation.

Basis Points says...

"The idea behind cutting basis points is to extract forced savings from inflation vulnerable entities, and transfer the purchasing power to banks. Basically, a regressive tax that is given to the banking system, instead of the public. The theory is that this extra purchasing power will strengthen banks, and they will eventually be able to loan more."

This is equally backwards. The Fed does not give money to banks, it buys Treasuries on the open market. If you want some of that cash, sell a Treasury.

So where does the benefit of the newly printed money go? Primarily to taxpayers. They are the ones who will have to pay that debt off in taxes if the Fed does not instead print money to purchase it.

Of course this ends up causing some inflation, but taxpayers in general are not going to be the net losers there. Sure, some on fixed incomes are hurt more than others. What about banks? Well, they tend to be money lenders, so they tend to be hurt the most.

Thus, the Fed cutting rates is normally the last thing banks want to see. It not only does nothing for their short term bottom line (as both borrowing and lending rates are still set in the market), but it generally impairs the value of their assets (through inflation) in the long run. If the banks could have their way (and they often do), at times they might just as soon we have a rather large recession rather than cut rates.

This also brings us to the likely reason the Fed isn't cutting further. With some of those balance sheets already stressed, banks can't afford to have inflation reduce the value of those future payments. So what this suggests to me is that they are even more worried about the solvency of the banking sytemn than the evidence of economic slowdown.

So instead, we get the "bailout" through which they are trying to cut corporate lending rates, as well as buy up bank loans. Ironically part of what they are doing is what Fannie and Freddie have done for years; borrowing at "safe" government rates and lending it to borrowers who otherwise would pay higher rates.

The stuff about needing higher rates to increase savings is backwards as well. Market rates are low because there is already stronger aggregate savings than demand to borrow it. And the government, if they lower rates by buying up debt, would itself be saving (on behalf of taxpayers).

If you want to increase interest rates, one way to do that is to increase demand for those savings. So do government spending. Do something to increase capital investment. You will then see interest rates rise.

As for the Zimbawee stuff, sure if you want to target rates, and float the money supply, that might be a problem, but I don't think that was what was suggested. There's no reason you can't increase the money supply through purchases on the long end in the context of inflation targetting. And it would have some impact on rates. It's not as though there is no middle ground between Zimbawee and deflation. The Fed has pretty consistently hit about a 2% PCE target now for over a decade. No reason that number couldn't be 3.5%, if that was the target they wanted.

[Winslow R.]

Feng wrote : "Anytime the economy shows even the hint of a slowdown, leftists scream and whine for government intervention to stop the decline."

Feng aka Phil Gramm?

Just how far do you want the asset price level decline to go? Theoretically the government could allow the price level to decline zero. Zero not far enough? Government could even take it negative.

Given asset values are denominated in government currency, any price level above/below zero is 'artificial'.

I prefer the asset price level to be above zero, I guess I'm whining :)

[Winslow R.]

"It is effectively a tax on wealth, thus it mostly taxes the wealthy. Incomes will generally increase with inflation (if the source is truly monetary). I fail to see where the top 10% are finding loopholes to get out of inflation."

We are in deflation and the wealthy tend to be in assets and in many cases leveraged real assets. Not a good place to be in a deflation.

Inflation hurts the wealthy that are holding fixed rate financial assets. The wealthy want to be holding real assets leveraged with fixed rate loans during an inflation.

[James Kroeger]

Its not the fact that we issue bonds that prevents inflation, it is the fact that the bonds are sold overseas.I'm not sure if you're fully congnizant of the fact that when China buys Treasury bonds, it keeps dollars in the US economy that might otherwise have been removed from it. Nothing really changes; it's simply that the owner of the piece of paper happens to live on the other side of the world.

Where were those dollars before the Chinese obtained them from US importers? In some US bank as part of its loanable reserves. Now if the PBOC were to simply hold those dollars outside of the US economy, then the effect would ameliorate inflation as you suggest, but that is not what they do.

Now if for some insane reason the Chinese were to try to get rid of all their dollar denominated assets, and then they just held those dollars outside of our economy, then we would have a problem, but only if the Fed were to decide not to buy up those securities, itself.

[the buggy professor]

"The Fed's power to determine interest rates is absolute because it has absolute control of money supply." --- James

.....

(i) No, the Federal Reserve does not absolutely control the money supply. There are three variables here:

1)the money supply itself (currency and bank demand deposits) is the outcome variable of two independent variables:

2)the monetary base: currency and bank reserves

3) and the money multiplier: a function of the reserve-deposit ratio AND the currency-deposit ratio.

The Federal Reserve can only directly influence the monetary base. It cannot oblige 1) either banks to lend all money to businesses and households held by them above their reserves; or 2) to induce the public to deposit money in demand deposits.

.........

(ii.) In the Great Depression, to illustrate this, the Federal Reserve expanded the monetary base 18% between 1929 and 1933.

But . . . well, the money supply itself (remember, currency and demand deposits) fell 28%.

Why? Because the money multiplier --- which was 3.7 in August 1929 --- fell to 2.3 by March 1933 when FDR came to office . . . a drop of 38%.

......

(iii.) In short, in the Herbert Hoover period, the Federal Reserve did try to expand the money supply, but failed badly.

That failure resulted from a confidence problem: the public feared putting currency into bank deposits, and banks --- fearing a run --- were reluctant to lend out much money. (Of course, the Fed Reserve could have doubled or tripled its efforts to increase the money supply, but that’s another matter.

.....

(iv.)And that, folks, is where we might be now were it not for a far more active Federal Reserve and the amended Treasury rescue-plan --- which is hardly perfect, but will, let us hope, do something effective in the next few weeks to ward off a confidence-crisis of the sort that spiraled out of control between 1929 and 1933 (when FDR came to office). In that period, the US GDP fell more than 35% and unemployment rose quickly to 25% or so . . . and not least because the entire credit-system ground to a halt, not just in the US but in large parts of Europe too and in Japan.

.....

(v.)Raising the deposit insurance level is a good start too --- it didn't exist between 1929 and 1933. Dealing with falling house prices and defunct mortgages would also help probably (various schemes are vented). And, if need be, the Fed and Treasury could emulate the Swedes and do what they did to stop in the tracks a similar housing price collapse and financial mortgage problems by simply buying lots of equity in the commercial and investment banks there . . . an effective way to recapitalize the banking system quickly and deal directly with the mortgage problems themselves.

Above all, we need to fight off a confidence-crisis that can, once it gets under way, become self-fulfilling. And that, in turn --- alas for the libertarians here --- will spell the end of the deregulation and poorly administered regulatory agencies in the Reagan - Bush - Clinton - Bush era.

Or as Chris Cox, the ineffectual chairman of the SEC put it recently, he was wrong to think that financial markets could be self-regulating. They need to be carefully regulated, made subject to government enforced rules, and be made in that manner to be transparent and accountable and stop pretending that investments of any sort aren't risky and volatile . . . with the risk somehow passed on along a global chain to various other enterprises in repackaged and imaginary insured ways.

....

Michael Gordon, AKA, the buggy professor

[Gerard MacDonell]

I think the adult thing to do here is to advocate policies that are most likely to prevent a big rise of unemployment and the human misery that would inevitably attend that. If that is not your main concern, if you are more interested in
scoring a point for your "philosophy", then maybe you might want to think again.

[BJ Feng]

Chris Cox, like all politicians, and unfortunately, many career bureaucrats, is covering his own ass. HE was the regulator for Lehman, and Bear! It was HIS responsibility to make sure they were well capitalized. Well he failed and now wants to say that there wasn't any regulation. I guess if you're the guard, and you're asleep at the post, it's best to claim that there never was a policy to guard in the first place. That way, maybe you can get your old job back if people are stupid enough to believe you and make you the "new" guard.

People like Cox exemplify the problems with regulators. Regulators need to be smart enough and knowledgeable enough to stay ahead of the game. They must be a type that doesn't need social acceptance or approval, who can steel themselves against criticism because they must be the ones who slam on the breaks during a boom, effectively ending the party for everyone before great harm can be done. That's a lot to ask, and there aren't that many people who are capable of doing such a task. Most of the time, you get the career bureaucrat who just wants to keep his job, and understands that ending the party when nothing's broken YET, will cause a huge amount of resentment and make him very unpopular with everyone, even politicians. We have to take into account what we're likely to get, that's realism, things rarely go as planned in reality.

Look at Shelia Blair, the FDIC head and what she said after IndyMac bank was taken over. She said the government would modify loan terms to keep houses out of foreclosure. She also screwed up the Wachovia deal, both Citibank and Wells Fargo said that she approached them, unfortunately, Citibank wasn't aware that Wells was negotiating with her when Citi already thought they had a deal late Thursday

"At that point on Thursday, the agreement between Wachovia and Citi was all but nailed down; they'd even scheduled a time to sign it -- 2pm on Friday. Of course, that never happened. And it looks very much, from Steel's affidavit, that Bair had been working behind the scenes with Kovacevich and the crew from Wells Fargo, putting together a rival deal.."

http://www.portfolio.com/views/blogs/market-movers/2008/10/06/the-duplicitous-sheila-bair

Yes there are circumstances when we need regulatory reform, or even more regulations (rare as those times might be). But often it's the effectiveness of the regulator, not more regulations that we should point to.

[BJ Feng]

Inflation would hit the rich the hardest if there weren't ways to protect against inflation. We have TIPS, and equities provide shelter to some extent, but the rich also can move their money to another currency.

Actually the poor have most of the tools available to them too, they just aren't educated enough to use them. Incredible that anyone would keep a substantial amount of money in a bank account nowadays with money market mutual funds out there. And only the poor use bank savings accounts to hold their savings. Hello, you can buy US Treasury Debt directly from the government with zero transaction costs! And the minimum is just $100! Why would you ever keep your savings in a lower yielding bank account? The rich don't, which is why they are rich.

[Hello]

BJ Feng says...
"...they just aren't educated enough to use them"

10yr US Treasury Note is running about 3.5%
Highest Rated Individ. Money Mkt. Mutual Fund is about 4.75%

While an FDIC insured guaranteed rate on 1 yr certificate of
deposit can be found at in the neighborhood of 3.7%

So you must be an anomily...are you a dumb rich guy or that rarely seen intelligent poor person.

[James Kroeger]

No, the Federal Reserve does not absolutely control the money supply....The Federal Reserve...cannot oblige 1) either banks to lend all money to businesses and households held by them above their reserves; or 2) to induce the public to deposit money in demand deposits.The Fed may not be able to compel commercial banks to lend all the loanable reserves it gives to them, but it has always been a safe bet that private banks will nearly always lend all they are permitted to lend. The more and more and more they obtain, the more risk they are generally willing to assume.

As I pointed out above, it doesn't really matter if there are any savings. If all savers were to pull all of their deposits out of all banks in the next week, the Fed would still be able to easily maintain interest rates at whatever level it desires by simply buying up every debt instrument in circulation in the economy. If that were not enough, it could buy buildings or land or any other kind of real asset. When savers are reassured that their money would be safe, the Fed would be able to selling the paper back to banks, etc.

[Arman (Allan Manchester)]

"It is arguable that rate cuts have done little to stem the tide of deleveraging that is ravaging the banking system."
I say that the rate cuts are the entire source of the problem, and I am elated that the fed is rethinking its strategy. Lower interest discourages lenders from lending. Higher interest encourage lenders to lend. Before the Fed started cutting rates September 07, everything was stable. The more that the rates were cut, the more that there seemed not to be enough cash in the system. Without a cut this month, you will at last see some stability next. Of course the politicians will pat themselves on the back for that stupid bailout, but what can you do?

[Winslow R.]

"Lower interest discourages lenders from lending."

You have much work to do.

Start with the difference between long and short term interest rates (the rate the Fed keeps tight control over).

[Arman (Allan Manchester)]

Money is a creation of the local bank in its lending operations. The fed printing service is NOT the source of money. You are alluding to the popular concept that the local bank works off the point spread. No! The paper that the bank gets from the fed is an addendum to the money supply, and not at all the source. For every $100 that the bank creates, they are sometimes supposed to get $10 from the fed. The fed's adjustment of rates do almost nothing to the costs of the local banks cash creation activities. It only puts pressure on the profitability of those activities.