Monday, December 15, 2008

Firing Blanks

The US Federal Reserve convenes its two-day meeting today to deliberate on the direction of monetary policy. Expectations are for a cut of 50bps, which would bring the fed-funds rate to a historical low of 0.5%.

Given that most of the normal channels through which monetary policy works (eg. housing, credit, investment) are either severely jammed or completely broken - there will likely be no material stimulative impact from a rate cut. Moreover, the effective funds rate has been trading at below 50bps for quite some time, and it is still unclear how the decision to pay interest on reserves has impacted the usefulness of the fed-funds rate as a policy instrument (see here for an excellent discussion).

There also may be significant risks to cutting rates , most prominent, (as Tim Duy notes) of which is a disorderly adjustment in the US dollar. A falling dollar, along with massive borrowing associated with bailouts and a coming stimulus package, could send interest rates higher as countries demand higher compensation on US government debt (though this hasn't happened in the past couple of years, despite a weaker dollar and massive borrowing). Moreover, as global trade deteriorates, there may be none of the typical stimulative trade effects normally associated with currency depreciation.

What are the risks if they don't cut? Who knows. Uncertainty is scary and markets are too fragile not to deliver on expectations which is why the Fed will continue towards the zero bound with their hands firmly gripping the monetary spigot.

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