Last month, we saw the Federal Reserve cut the Fed Funds Rate a full 125 basis points (1.25%) to 300. What does that mean historically? In the following article we will take a look at just how dramatic the Fed’s 125 basis cut in 8 days means.
The Fed started issuing “Target Rates” in 1982. Before then, the free market set the prevailing rates. Now, the Fed through the open market works to get the rate to its target. Here is the graph of the Target rates since 1982:
As is plainly visible, the Fed has been slowly lowering Fed funds rate since it started controlling it back in 1982. What does this mean? Basic economics says that the power of a central bank depends largely on how they control interest rates. Generally the higher the interest rates are before coming recessions, the more power the Fed has to flush the economy with money and increase liquidity. Following this logic, we can see that the Fed has been slowly loosing its power to provide liquidity relative to previous recessions.
If you were to actually look at the rate the Fed has cut its Fed Funds rate, there has been no precedence for cutting 125 basis points in 8 days. The closest we have come is a 100 basis point cut in the time span of a month. What does this mean? Although, many can argue that differences in styles of Chairmen of the Federal Reserve would bar extrapolating long term trends, this could mean a couple of things that are not mutually exclusive of one another.
One: We can be seeing a new type of Fed. A Fed willing to forgo the typical steady prolonged cuts of the past. This could simply be a change in style from Greenspan to Bernanke. Possibly an “experiment” of a new way to set target rates.
Two: The Fed is acknowledging that it was late in beginning to cut rates. There have been critics of the last fed funds rate rises and the slow reaction time of the Fed to begin cutting rates. This could simply signal that the Fed is trying to “catch up” with the economy.
Three: the economic downturn we are headed for is unprecedented and the Fed is ready to take drastic actions against the coming recession. After all, desperate times call for “drastic” measures.
However, the most important question is: How much can the Fed Cuts help in this coming downturn?
Let me reiterate this: They obviously help. But how much?
Basic economics tell us that with Fed cuts comes easy money. In theory, banks can more easily lend to other banks or from the Fed to solve liquidity crises. But is that the case during this cycle? Although, some would say this is a “consumer led” downturn, I would argue otherwise. This cycle has been created by the willingness of banks to lend money frivolously, headless of risk. The problem today is that banks don’t have cash reserves to lend out to other banks. Look at my previous post, “One Reason Last Week’s Market Rally was a Bear Rally,” to see just how hurt banks are with cash. The level of borrowing from the Fed is, again, unprecedented. This along side the fact interest rates have been historically trended downward, limits the immediate help the Fed can give to banks in the short term.
Here is a chart of what the Federal Reserve has had to deal with since the 1960s:
Generally, until 1982, the Fed had to actively fight inflation, or “Stagflation.” Since then, after every recession, or threat of deflation, interest rates have not risen to the levels before economic downturns. In other words, the Fed’s power to stop deflation has been curved. This, along with liquidity problems in the financial industry, leave the Fed with one hand to save the economy.
Question to ponder: If we have not had interests rise above their previous peek after every recession since 1982, what makes this recession different? If anything, we should expect a longer period of low interest rates due to the limited power that the Fed has to stop us from going into a serious recession, or curving deflation.
This is an informative post. Thank you.
I am typically an optimistic investor – trying to buy low and sell high. However, I am now fully turned around and believe that in order to make money over the next several months (at least) is to short – sell high and buy lower.
*sigh*