On Friday the Federal Reserve lowered the discount rate 50 basis points (half a percent) to 5.75%. While this is not the complete panacea the markets want, it could be the first step in cutting the Fed Funds rate at the September FOMC meeting. I have argued against a rate cut in the past and continue to do so. However, this rate cut exposes an incredibly blatant double-standard in the Republican's ideology.
First -- what exactly happened on Friday?
US banks use a fractional reserve system. All this means is a bank much have x% of its total assets on hand at any given time. However, in a banks usual business affairs their reserves may dip below this percentage amount. When this happens, banks must borrow short-term money from somewhere. Usually, they go to other banks. The interest rate banks charge each other is the Federal Funds rate. In addition, a bank can go directly to the Federal Reserve and borrow money. The Fed will charge the bank the discount rate. Going to the Federal Reserve to borrow money is a last resort and is usually considered a sign of weakness. Therefore, lowering the Discount rate is largely a symbolic gesture because it isn't used nearly as much as the Federal Funds rate.
In face, some have argued this is actually a delaying tactic that will allow the Fed to not lower rates:
Federal-funds contracts traded on CME Group suggest market participants see the Fed cutting rates by a half-percentage point at the September 18 meeting. But don’t put that in the bank just yet. Though the actions taken by the Fed were meant to bolster confidence in the financial system — and the Fed encouraged banks to use the discount window, which normally carries a bit of stigma – some believe the move today is a way for the monetary committee to buy itself more time, and perhaps even lessens the possibility of a rate cut in September. "We believe the action reduces the overriding worry that the mortgage market would grind to a halt," says Standard & Poor’s chief economist David Wyss. "It also buys the Fed time to assess the situation and possibly not act on the Fed funds rate until September."
The simple matter of predicting anything right now is we really have no idea what the Fed will do. My guess is they are taking a gradual approach to the problem and are still trying to do the least possible. However, that does not absolve them of their responsibility vis a vis the current economic situation.
As I outlined in this article, the basic problem in the economy right now is speculative excess in certain types of debt instruments. The best way to cure this problem is to let those who made bad investment decisions fail. Then, the next time around someone wants to do something similar they'll think to themselves, "last time a lot of people lost a lot of money and the Federal Reserve didn't bail them out. Maybe I shouldn't do that."
This is what is referred to as moral hazard:
Wall Street has a dream: that the Federal Reserve will rescue financial markets with a sharp cut in interest rates.
Behind that dream lurks a problem, something financial people call moral hazard.
Moral hazard is an old economic concept with its roots in the insurance business. The idea goes like this: If you protect someone too well against an unwanted outcome, that person may behave recklessly. Someone who buys extensive liability insurance for his car may drive too fast because he feels financially protected.
These days, investors and economists use the term to refer to the market's longing for Federal Reserve interest-rate cuts. If investors believe the Fed will rescue them from their excesses, people will take greater risks and, ultimately, suffer greater consequences. Some grumble that the Fed created problems this way in 1998, 1999 and 2003.
If the Fed were to cut rates now, it certainly could help with the current market crisis. The cheaper money would reduce pressure on stock and bond markets by making it easier to buy beaten-down stocks, bonds and other securities world-wide. Wall Street is a powerful lobby in Washington, and its bleating for help can be hard to resist for politicians, whose campaigns often depend on financial contributions from Wall Street figures.
But if the Fed were to ride to the rescue, the skeptics worry, it would encourage people to speculate even more, creating an even bigger bubble later.
"You don't want to see the Fed bail out these guys who have made a lot of money. They have made their bed and you want to see them lie in it," says a veteran trader at a New York brokerage house. "Then again, you don't want to see the economy go into recession."
That, in a nutshell, is the choice the Fed's policy makers face today.
In other words, lowering interest rates right now will promote the behavior that got us into this mess.
My favorite Federal Reserve Chairman is Paul Volcker. He became Fed chairman in the late 1970s when inflation was running very high. Volcker raised rates to high levels to wring inflation out of the system. Volcker basically caused a recession and was pilloried for it. However, in retrospect this was the right thing to do. Yes, the recession was bad. However, the alternative was worse. Runaway inflation is what destroys countries in the long-term. This is the example that all Fed governors should aspire to.
However, cutting the discount rate exposes the soft-underbelly of "free market" Republicans. When hedge funds lose money, they screen and yell that the Fed should cut rates to save them from their stupidity. But national health care is "socialized medicine" that must be stopped at all costs. In other words, they want it both ways.
In my opinion, let the big boys learn their lesson the hard way -- which is usually the only way to actually learn a lesson anyway. Supposedly these people can take care of themselves. So let them.