Force and failure of the fed funds rate

BY MARJORIE KORN — MEDILL NEWS SERVICE

Last week Alan Greenspan, former Maestro and chairman of the Federal Reserve Board, said his mea culpas for allowing interest rates to stay so low for so long, making lending and borrowing too easy.

Those with a taste for irony got their fill Wednesday as the Federal Reserve lowered the fed funds rate by 50 basis points to a shallow 1 percent, the lowest since Greenspan oversaw interest rates in the summer of 2003.

Now Chairman Ben S. Bernanke and the other members of the Board of Governors seem to think that the economy’s poison is also its antidote.

Monetary policies enacted by the Federal Reserve are supposed to matriculate through the economy as early as six months following action. Yet with Tuesday’s Wall Street rally which pushed the Dow up nearly 900 points on speculation that the interest rate would be lowered, gradual economic change has been usurped by dizzying volatility. Bernanke no longer has the luxury of looking long-term because the market reacts instantaneously.

This is the second rate change of the month, but market reaction has been more positive this time. Despite a similar 50-basis-point rate cut on Oct. 8, the Dow fell by a few hundred points before sinking to below 9,000 on Oct. 10, a watermark it hasn’t been able to best for more than a day since.

This is because the central bank doesn’t work in a vacuum. Though Bernanke preempted the rate change in a speech Oct. 7 in Washington, the market was still being pummeled by rising unemployment, disappointing quarterly earnings, and growing evidence of worldwide recession.

Add to that the Fed’s dual mandate of maximum sustainable growth and price stability, which critics contest are ultimately mutually-exclusive. The Fed is trying to reinvigorate growth which, as measured by the GDP, can only be described as lethargic, and to hell with price stability because, hey, the rampant inflation the country faced over the summer is tempered by rising unemployment (but please don’t say that nasty “s” word – stagflation).

Bernanke is dealing with a gigantic Rubik’s cube, trying to line one side of colors up but potentially dislodging the order on another face.

But these are not the only paradoxes surfacing in the midst of all of this, for the Fed is now facing paradoxes of ideology.

The markets are now being told they have been naughty and need regulation. Lots and lots of regulation overseen by the same Congress who, mind you, were more than happy to turn a blind eye to shady practices when the economy was hot.

Ayn Rand – the laissez-faire capitalism-loving novelist and philosopher – must have been rolling in her grave as Greenspan, one of her most successful disciples, was taken to task for balking at market regulation.

And so the pendulum will swing, as it always does, from one extreme to the other. The sentiment shared by policymakers and market participants seems to be “Do what it takes to fix the market in the near-term, and we’ll reevaluate when normalcy returns.”

This thinking is riddled with danger. For starters, what does normalcy look like? The landscape of banking has changed so dramatically it will be impossible to compare the new economic order to the one that has dissipated in the past six months. Moreover, in our haste to duct tape up the façade of the economy, we could be exacerbating inherent problems.

J. Paul Horne, an independent market economist from Alexandria, Va., warned earlier this month, “The liquidity tsunami which we had in the early part of the century may be reiterated in the next couple of years. In other words, a flood of cheap liquidity aimed at resuscitating the financial sector, getting rid of the credit crunch, saving the real economy, may lead to a round of inflation that begins late next year and continues into 2010.”

Drop the fed funds rate to loosen credit. But is that what is ultimately needed?

No doubt a myriad of books will be penned to make sense of what happened and to predict what’s to come. But perhaps Mark Twain, the perennial satirist, put it best: “History doesn’t repeat itself, but it does rhyme.”

Photo used under a Creative Commons license courtesy of TrackRecord.

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