How The Fed Can Avoid Cutting Interest Rates

Should the Fed cut interest rates? A lot of the market thinks it should, and

even more of the market thinks it will. But there are adverse consequences to

such an action, especially on the inflation front: if the dollar weakens further

on a rate cut, then prices could start rising faster than the Fed is comfortable

with. And keeping inflation in check is much more important, for a central bank,

than rescuing bond investors.

On the other hand, helping out the credit markets is a good idea, and important.

And it just so happens that there’s a good way for the Fed to do that which

doesn’t involve an outright Fed funds rate cut. Here’s

William Polley (my emphasis added):

Today’s intervention was just a ripple in an ocean, but in the event that

something more is on the horizon, the Fed needs to remind banks that the discount

window is always there to meet their emergency liquidity needs. If anything,

the Fed might consider lowering the discount rate to marginally encourage

borrowing from that source rather than putting strain on the fed funds market.

Lowering the fed funds rate should not be the first reaction to this situation

despite the fact that many people will call for it. Lower the fed funds target

only if it looks like this is not going to be contained by the financial markets.

I like the idea of the Fed cutting its discount rate – which is currently

at 6.25% – rather than the Fed funds rate. That would improve liquidity

in the markets, without having an adverse effect on the dollar. What the markets

need right now is abundant money, rather than cheap money.

All this talk of "liquidity" only serves to blur the distinction,

since the word can have either meaning, or both. But the Fed can definitely

provide the former without resorting to the latter.

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