Did the Fed Do Enough by Lowering the Discount Rate?

On Friday the Federal Reserve lowered the Discount Rate, the rate banks must pay to borrow money from the Fed, from 6.25% to 5.75%. The Federal Reserve lowered the Discount Rate to try and ease the credit crunch that was starting to spread from the sub-prime loan area into the general economy. By lowering the Discount Rate the Federal Reserve is saying to lenders that they will provide them with whatever liquididty they need at a reduced rate.

This was a proper move by the Federal Reserve as the main role of the Federal Reserve System is to provide liquidity to the banking system in times of need. If the Federal Reserve did not provide relief we would have started to see lenders calling in loans and causing a contraction in the nation's money supply. But did the Federal Reserve do enough?

The simple answer to that question is no. The Federal Reserve is stepping up and providing liquidity to the banking system in a time of need, as is mandated in the Federal Reserve Act, but the Federal Reserve has yet to address the real problem causing the credit crunch. Short term interest rates are too high given the low levels of inflation in the economy today.

Currently I am earning almost 5% in a money market fund with no restrictions of any kind. In a low inflation environment that is just too high. In order to earn a profit on my money market deposit the financial institution that is paying me the almost 5% must reloan the money back out to another party that will pay them back the 5% plus expenses plus whatever the financial company deems a decent rate of return for bothering to do the business. In a low inflation environment it's just too hard for average businesses or regular people to pay back such high rates of interest.

Lowering the Discount Rate did not really address this issue. The Federal Reserve did not lower the Fed Funds rate which most financial institutions use as a guage for setting short term interest rates, like my money market fund. My money market fund is still paying me the same rate of interest so the forces that caused the credit crunch in the first place are still in effect.

Short term interest rates are still too high given the low levels of inflation prevelant in our economy today. The same market forces that built up over time as the Federal Reserve slammed the economy by increasing short term interest rates from 1.00% to 5.25%, an increase of 5.25 times, over a short time frame are still in place. Though the Federal Reserve provided some relief by reducing the Discount Rate they have not solved the core problem yet.

To understand just how hard the Federal Reserve slammed the economy by increasing short term interest rates by 5.25 times over a relatively short time frame, the same increase today would take short term interest rates to 27.5%.

The Federal Reserve has two ways it can solve the core problem of too high short term interest rates. It can inflate the money supply and cause higher rates of inflation which will make it easier for businesses and regular people to pay back the current short term loan rates. Or the Federal Reserve can lower the Fed Funds rate. Otherwise the same market forces which caused the credit crunch over the last few weeks will again build up and cause it to happen all over again.