The US Federal Open Market Committee’s half-point cut in its federal funds target does not address the leverage and credit issues in the banking system. Indeed, it doesn’t solve short-term problems and worsens long-term inflation worries.
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The banking crisis was not caused by high interest rates. Its two main causes were large and unknown housing-related and other credit losses and an urgent need for banks to reduce their leverage. Those problems are being addressed by huge Fed liquidity doses and plans to inject $250 billion (Rs12.4 trillion) of new capital into banks. Reducing already low interest rates will have no significant effect in alleviating the causes further.
By cutting to 1%, the Fed has moved close to its limit; it had decided in 2003 that cuts below that rate would be damaging to the money market fund sector. Such low interest rates discourage saving and encourage borrowing, precisely the reverse of the appropriate prescription. Much higher rates, giving savers a real return and bringing supply and demand for funds into equilibrium, are needed in the long term.
The Fed has avoided addressing inflation, and appears to think the problem has solved itself. Yet its rate cuts amplified an unprecedented commodities bubble, which has only been reversed by the global downturn. With monetary and fiscal policy both wildly expansionary, there must be some risk of the commodities bubble reinflating; oil’s 7.6% rise on 29 October and gold’s recovery from $698 per ounce to $754 in four trading days suggest that possibility is real.
There is nowhere now for rates to go but up. The sooner the central bank can reverse course, the better.