Analysis of Federal Reserve Interest Rate Cuts

After slamming the US economy by raising the Fed Funds rate from 1.00% to 5.25% over the 3 year period from 2003-2006, the Federal Reserve reversed course yesterday and lowered the Fed Funds rate by 1/2 point to 4.75%. In effect, the Federal Reserve admitted yesterday it had raised the Fed Funds rate too high and too fast and that the effects of their raising the Fed Funds rate by 5.25 times from what it was in 2003 were damaging the US economy. The Fed also cut the Discount Rate yesterday by 1/2 point.

What can be expected from the rate cuts?

The most important result will be that financial institutions will now start paying lower rates of interest to depositors which means that the banks will now also charge lower rates of interest to borrowers. Important because at 5.25% the Fed Funds rate was forcing financial institutions to pay very high rates of interest to depositors for the use of their money in the short term. This forced the financial institutions to charge very high short term rates to borrowers and in a low inflation environment many borrowers simply could not afford to pay back the loans. Delinquent loans have been rising very rapidly lately.

The cut in the Fed Funds rate will ease the burden of high short term loan rates on many borrowers. Which means that fewer borrowers will default on their loans. The Federal Reserve is trying to contain the effects of their massive rate hikes which were having a very detrimental effect on the US economy, especially in the housing sector.

Did the Federal Reserve do enough?

Clearly in a low inflation environment 5% plus short term interest rates cannot be sustained. Only the best businesses and most financially secure individuals can afford to pay such exorbitant rates in a low inflation environment. The Federal Reserve has now ensured that short term rates will drop below 5% but what is the proper rate of interest for short term loans in a low inflation environment? It almost certainly is lower than 4.75%. So the Federal Reserve has taken a step to help ease the problem but until short term rates are at their proper levels for a low inflation environment the US economy will not grow at its maximum output.

What is the proper level for the Fed Funds rate in a low inflation environment?

This is the critical and key question for the Federal Reserve. The question the Federal Reserve should be, and always should having been, putting its time and efforts into trying to figure out instead of trying to micro-manage the US economy. The US economy does not, nor did it ever, need to be micro-managed by a small group of people in Washington, DC.

A 5.25% Fed Funds rate is not sustainable in a low inflation environment and the current crop of Federal Reserve Board members clearly understand that now.