Tuesday, December 16, 2008

Fed Formalizes Existing Fact

The Fed went further today than I and most other analysts had expected in their lowering of the official target for the Fed funds rate, lowering it to [for the first time it's a range and not a specific number] 0-0.25%.

This won't make much difference as the Fed had for weeks kept the effective Fed fund rate in that range since December 4. Judging by the rally in stocks, bonds and most commodities (except oil, for some unknown reason), and the sharp sell-off in the dollar, however, it appears to have a short-term psychological effect on traders unaware of the fact that the Fed had already lowered the effective rate to that level.

This effectively means that that the Fed has run out of ammo, in terms of lowering interest rates. But for those of you fear or hope for deflation, there is no need to worry or cheer on account of that. You see, they still have the form of ammunition known as quantitative easing available, which in effect means the ability to buy assets and paying for it through the printing press. And they are already suggesting that they will target the assets whose price are most depressed now.

And if you think Ben Bernanke will hesitate to expand the Fed balance sheet by whatever amount it takes to reignite inflation, think again. Inflation will therefore return.


Blogger Reginald said...

Is this the same sort of stagflation in the late 1970s?

11:41 PM  
Anonymous newson said...

"The U.S. central bank has taken care to limit credit risk by...loaning less than the value of collateral when it is of less quality than U.S. Treasuries.

stefan: is this not the very bone of contention? the fed's loans to commercial banks are subject to what sort of scrutiny? surely it's totally counterintuitive to imagine the fed is not being extremely generous with its valuation of banks' toxic paper. this distinction between a liquidity and an insolvency crisis seems totally meaningless.

1:24 AM  
Anonymous Anonymous said...

Doesn't this also mean that the Fed stops paying interest on reserves?

This seems like an attempt to force banks to lend rather than hoarding reserves, and as such is highly inflationary.

It IS a change, but not for the reason most people assume.

3:11 AM  
Blogger stefankarlsson said...

Reginald: no, not exactly the same as the one in the 1970s was the result of a more gradual upward trend in inflation as well as the oil shocks. Here it is instead a case of the Fed flooding the economy with money in an attempt to reflate it during a severe slump.

Newson: Of course they will be very generous with their valuation, but they will naturally pretend that they aren't.

Anonymous: They will continue to pay interest on reserves, but only 0.25%. As long as changes in reserves are accomodated by changes in the Fed balance sheet, they will not have much effect in that respect. To the extent that larger reserves makes banks feel more secure, such increases could increase lending.

8:09 AM  
Anonymous Anonymous said...

> They will continue to pay interest on reserves, but only 0.25%.

Well, yes but the difference between 0.25% and the effective FedFunds rate is dramatically less than the difference between 1.0% and the same effective FedFunds rate.

A scheme which was once enormously profitable for the banks is no longer.

4:01 PM  

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