Why the Fed will cut the target rate

With the Fed meeting approaching in a few hours, most are predicting they'll cut their target fed funds rate by a quarter point—so I thought it would be a good time to update the interest rate tracking chart.  Click to enlarge.

We haven't seen interest rates this low for more than two years, and short term rates have dropped sharply in recent weeks, suggesting a flight to safety.  The bond market participants don't appear to see higher inflation on the horizon; is it possible they see disinflation, or even deflation, instead? 

The highest rate on the chart today is fed funds, which exceeds even the 20-year T-bond.  It looks to me as if the market is telling the Fed it needs to cut, maybe by a full half-point.  Unanticipated deflation is arguably just as harmful as unanticipated inflation, so count me in favor of a half-point cut in the target rate, to fight off the recession so many are predicting (and seemingly hoping for).

Comments

It seems to me like the recent history of the Fed is too much, too fast, in either direction. Too loose a policy too fast fostered the tech bubble and the housing boom (which was also, arguably, a bubble). Too tight a policy, too fast didn't just pop the tech bubble, it threatened the whole economy and left many NASDAQ stocks in an unjustifiably cheap range even today. Too tight a policy, too fast meant that instead of housing prices cooling a bit there is a full blown housing recession that threatens the rest of the economy. Now loosening is creating a bubble in energy that isn't justified by the fundamentals. If stability is important (and it is), 25 basis point changes with at least one intervening meeting with no change at all ought to be the rule.

[Ron Hardin]

The short term interest rate itself is of no interest; it's got an arbitrary scale, in effect.

What it is that's of use to the Fed is a way to gauge the adding or removing funds from the money supply. It decides on other grounds that the money supply is too high or too low, and in response raises or lowers the target interest rate ; that in turn regulates the adding or removing of funds, which will be a little different in the desired direction from what it was before.

The way the economy responds to adding or withdrawing funds will over several months change, and again based on other indicators the Fed may change the target again for that reason as well as because the needs of the economy change. The former relates to the absolute interest rate not being the point.

Interest rates themselves get discounted a lot because they respond directly to the Fed's target, and so the Fed blinds itself by intervening, if it uses interest rates as an indicator.

The whole trick of managing inflation is using leading indicators of inflation that are orthogonal to interest rate changes, if you target interest rates to govern the changes in the money supply. For the Fed's intervention at the point of interest rates blinds the Fed to what the economy needs, if it uses those same interest rates.

Accordingly, interest rates are not much of an indicator of what the Fed will do, or needs to do.

Instead, find out what their leading indicators of inflation in fact are. Probably some constantly changing mixture of economic indicators, closely guarded.

[Ron Hardin]

Incidentally the limit the Fed has to always skirt is the deflation trap, if inflation gets too close to zero. If that happens, the Fed loses control of the money supply because people stop spending no matter how much money you throw into the economy. Why buy today when it will be cheaper tomorrow?

So they get only as close to zero as they dare, to avoid that possibility.

[Bob]

Steve:

Commercial paper yields are spiking up again. You can view them at the Fed site. I think that has the Feds attention. That and the prospects for a less than stellar Q4.

Deflation is much worse than inflation because it is the destruction of wealth. Not to worry, though. We'd have to see more downward pressure on commodity prices and a much gloomier stock market for that to be a consideration.

[Ethyl Added]

If you're at all in the Austrian camp, a recession can be seen to resolve misallocation of resources built up during boom phases. The housing market sure looks like a major misallocation that is being corrected right now. Financial "innovation" is another area.
Trying to save these areas from any further correction is the very opposite of a free market approach. Yet lowering interest rates now is consistent with attempting to do just that.

[Kevin]

Say, what happens with the interest payment on TIPs in the case of DEFLATION? Does the government send you a bill??

Never thought of that before.

[Bob]

Well, the stock market didn't like the 25 bp cut at all. Perhaps the Fed is waiting to see what Q4 looks like before more cuts.

All this talk about deflation with high commodity prices. Can't see it unless global demand somehow slows dramatically and even then it seems to me that unwarranted speculation is driving up the futures markets.

[The Practical Skeptic]

Central planning typified by the Fed's iron fisted control over the nation's economy perverts free market capitalism.

Everyday Americans are being taxed through inflation which robs them of the value of their savings and homes to rescue mortgage companies, hedge funds, and traders who made poor investments in subprime mortgages.

And what does the Fed do? "Rescue" those who made bad loans or invested in bad loans with our money.

Market intervention by the Fed only amounts to more bubbles and more bursts the so called "business" cycle.

A return to sound money cannot come soon enough for the average American like me.

The Practical Skeptic