I spend time watching the Fed. Much of that time is wasted, but they are an important cog in the machine that is our economy. Today, around 2:15 when the Fed’s policy statement is released, and the guy on CNBC at the Fed talks into the mike that sounds like it is a coffee can, many will focus on the change in the Fed funds target rate. I am here to say that given the changes that have happened in our economy, and the new ways that the Fed conducts its policies, the Fed funds target rate is not all that relevant. Why?
- The Fed does most of its direction of incremental liquidity through special programs like the TAF, TSLF, PDCF, ABCPMM, rescues, etc. It doesn’t send most of the liquidity out through the banks, and perhaps into the economy more generally (if the banks would lend).
- The Fed is having a hard time targeting Fed funds in an era where they can pay interest on excess reserves. Effective fed funds has been averaging 0.75% over the past 10 days.
- The closer we get to the zero bound, the less punch the Fed has through ordinary monetary policy. Expectations of policy failure swamp the cash flows involved, at least for a while.
- Real short-term lending rates are at present not connected to Fed funds. That includes semi-real rates like LIBOR, and somewhat more real rates like A1/P1 commercial paper, and real short term rates like A2/P2 CP, where only the free market is lending, and the Fed is not.
If the Fed funds target falls to 1%, and commentators trot out Greenspan’s name, remember this: the two situations are not the same. In 2003, the banks were healthy, and there were still areas of the economy that could benefit from lower rates and lever up, thus boosting GDP and markets. We got a housing bubble amid other consumer finance bubbles, and probably a bubble in commercial real estate as well. All of that added up to a bubble in companies that did lending.
A 1% Fed funds target will not have any punch this time around. Even 0% with “quantitative easing” a la Japan will lead to Japanese-style results, though again, only favored markets get the liquidity.
So, don’t expect much out of the rate. Read the announcement for what little qualitative information it might yield. I’ll be back with a compared version of the last and current statements later today.