Over the course of the Great Moderation, a lot of people forgot the difference between the Fed funds target rate (that's the number set at FOMC meetings) and the actual Fed funds rate (the actual, real, interest rate). No one forgot about that difference Friday morning, when the Fed funds rate was standing at 6%.
Then the Fed put out its statement:
The Federal Reserve will provide reserves as necessary through open market operations to promote trading in the federal funds market at rates close to the Federal Open Market Committee's target rate of 5-1/4 percent. In current circumstances, depository institutions may experience unusual funding needs because of dislocations in money and credit markets. As always, the discount window is available as a source of funding.
Let's backtrack here, for a minute. It wasn't all that long ago that the Fed funds target rate wasn't even public: banks had to work it out in a process of induction from where the actual Fed funds rate stood. The Fed would essentially communicate to the market where the target rate was by providing and removing liquidity until the actual rate got to where it was desired to be.
That mechanism remains, today. The way that the Fed controls interest rates is by providing extra liquidity when the Fed funds rate rises above the target, and removing liquidity when the Fed funds rate falls below it. So in that sense there's nothing special about the Fed's statement today: if the Fed funds rate is at 6% and the target is 5.25%, then it bloody well ought to be injecting liquidity. And even the Fed, with its slightly snippy "as always" (Jim Cramer, are you listening?) seems to be communicating to the market that it's just doing what it always does.
But the announcement is welcome, all the same. It's one thing to provide extra liquidity in theory. When you actually do it in practice in such large amounts, that's worth a press release.
Still, 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):
[Friday'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.