Why Tuesday's Surprise Rate Cut Won't Cut It

You’d have a headache too if you had his job.

We’ll never know how the market would have traded without the Fed rate cut but I have a feeling it didn’t make much of a difference.

I’ve been telling the Fed to cut rates since last summer so if you’re one of my 4 long-term readers, this is not new to you.

The Fed is continuing to chase the bond market in a cat and mouse game. Only problem is that the Bernanke Fed has been unwilling to do what is really necessary to bring the discount rate to alignment with the bond market.

It is the Fed that actually mimics the interest rate as set through the bond market (not the other way around). Tuesday’s 'surprise' 75 point basis cut may seem huge by historical standards but if you compare it to the short term T-Bill rates, you’ll see that much more is needed.

Greenspan had a much better track record in keeping the Fed discount rate as close as possible to that set in the bond market. See how close the black Fed rate hugs the blue short term bond market rate?

Since Bernanke replaced Greenspan in February 2006, we’ve seen a significant decoupling between the two. From early 2007 till now, the short term bond market has been consistently and significantly below the Fed rate.

This has exacerbated the liquidity crisis and it will continue to do so the longer it lasts.

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The “risk free” three month Treasury Bill rate closed at 2.35% yesterday. That’s 115 basis points below the brand spanking new discount rate of 3.5%.

All the Fed has done is cut the gap between the short term T-bill from 139 basis points (Friday) to 115 basis points (Tuesday).

Can you imagine what the market would do if Bernanke & Co. came out with a cut that size?

Comments

[David White:]

I'm sure it is not this simple. However, what you have said provides a very interesting perspective. Also I tend to agree that Bernanke has lagged the market much more than Greenspan. I think he got into trouble at the beginning. He raised one too many times to show he was tough on inflation. Then he compounded that by being slow to cut rates. His job is not an easy one though. It is much easier to take shots at him than to be in his position. We could do a lot worse than Ben Bernanke.

2008 Jan 23 09:50 AM

[flow5:]

Commercial Banks as a system don’t loan out anything. They create money when they make loans
Money creation is not self-regulating
You can’t take money out of the banking system (only the FED can)
Savings transferred through the intermediaries never leaves the CB system. The intermediaries are the customers of the CBs.
Savings held within the commercial banking system are lost to investment or to any other type of expenditure.
From the standpoint of the economy the banks shouldn’t pay for something they already have. Payments on savings raise all interest rates, induce disintermediation among the financial intermediaries, shrink real-gdp, & decrease CB profits.
The solution to our non-bank problem is to get the money creating depository institutions out of the savings business. Dah. Try reviewing 1966.

2008 Jan 23 10:00 AM

[flow5:]

As many people have noted, there have been eight boom-bust cycles in the housing industry since World War II. It is widely believed that those periodic crises in the housing industry are largely attributable to “disintermediation-whi... means that money flowed out of savings accounts in banks and thrift intuitions…Their solution? Have the Federal Reserve Board and other regulators…take the immediate step of raising the interest ceilings on new consumer time deposits nationwide by 1 or 2 percent…After a period of adjustment to this initial step, they advocate raising interest ceilings on all consumer savings accounts in all institutions now subject to loan associations and mutual savings banks. In their opinion, this will give financial institutions the flexibility to meet the needs of the housing industry.
I am certain their interest-raising nostrum, far from curing the patient, would actually create crises in the housing industry that could otherwise be avoided. Take, for example, the housing crisis of 1966. In Dec. 1964, the monetary authorities raised interest ceilings on consumer savings accounts in all insured commercial banks from 4.5 to 5.5 percent. During the next seven months-January 1966-July 1966time deposits in CBs increased by 10.1 billion, compared with an increase of less than 500,000 dollars in the savings accounts of savings and loan associations. Housing starts decreased by almost 50 percent and for a time it was almost impossible to obtain financing for the sale and purchase of existing houses.
A housing crisis existed, and the Federal Reserve authorities diagnosed the cause as disintermediation. But instead of raising interest ceilings, as others would suggest, the ceilings were lowered to 5 percent in July 1966. The effect of this reduction in interest ceilings on commercial bank held savings accounts was to sharply reduce the volume of “saved” demand deposits being shifted into time deposits.
Instead these deposits were transferred through the savings and loan associations-and consequently became available for the financing of the housing industry. During the August-December 1966 time period, time deposits in CBs increased only 2 billion, and savings accounts in S&Ls increased 3.1 billion. There was thus an immediate increase in the volume of loan-funds available to the housing industry, and the industry gradually recovered.
In the hope of forestalling similar future crises, the Federal Reserve authorities collaborate with the Federal Home Loan Bank Board to have interest ceilings imposed on S&Ls as well as the CBs. The ceilings become effective September 1966 with the proviso that the rates for S&Ls would be one-half of a percentage point higher-later reduced to one-quarter of a percentage point-than the ceiling rates imposed on CBs.
It is obvious from those data that the CBs suffered no disintermediation in the January-July 1966 period but the S&Ls did, even though they were not subject to any interest rate ceilings. Why this seeming contradiction?
Disintermediation occurred in the S&Ls because their loan inventory was mostly made up of 4 to 5 percent long-term mortgages, and they simply could not compete when most of the CBs chose to go to the 5.5 percent ceiling. (The S&Ls held large deposits with the CBs, the S&Ls were the customers of the CBs) The CBs suffered no disintermediation before or after the ceilings were lowered for the simple reason that the CBs disintermediation is not predicated on interest rate ceilings.
Disintermediation for CBs can exist only in a situation in which there is both a massive loss of faith in the credit of the banks and an inability on the part of the Federal Reserve to prevent bank credit contraction as a consequence of currency withdrawals from the banking system. The last period of disintermediation for the CBs occurred during the Great Depression, which had its most force in March 1933. Ever since 1933 the Federal Reserve has had the capacity to take unified action, through its “open market power, to prevent any outflow of currency from the banking system by forcing the banks to contract credit.
Unlike S&Ls and other financial intermediaries, the CBs suffer no disintermediation when savers decide to shift their savings to another type of investment. Shifting from TDs in CBs to nonblank types of investments has no effect on the total assets or the volume of earning assets of the CBs. It merely involves a transfer from TDs to DDs within the banking system.
CBs do not loan out TDs, DDs or the equity of bank owners. CBs acquire earning assets through the creation of new money. When CBs make loans to, or buy securities from, the nonblank public, new money-DDs-are created in the banking system.
The aggregate lending capacity of the CB system is determined by the monetary policy of Federal Reserve authorities. It is in no way dependent on the savings practices of the public. People could cease to hold any savings in the CBs and the legal lending capacity of the CB system, given our current institutional arrangements, would be unimpaired.
Insofar as there is an interest-rate solution to the problems of the housing industry, I would recommend that interest ceilings on savings accounts held by S&Ls and other financial intermediaries be removed and that interest ceilings be placed on all types of TDs in CBs. Existing Ceilings should be lowered-gradually. This action would decrease the proportion of TDs to DDs, increase the flow of funds available to the so-called thrift institutions-and vastly reduce the costs and increase the profits of the CBs

2008 Jan 23 10:06 AM

[James Biringer:]

I’ve been telling the Fed to cut rates since last summer so if you’re one of my 4 long-term readers, this is not new to you.

Thanks a lot, I got three. :)

2008 Jan 24 05:00 AM

[CM:]

How dare you ask the Fed cut rates and destroy our future. Inflation has been very high, our dollar is becoming rapidly worthless and we are turning into a Third World quickly right before our eyes. How on earth do you think they will ever be able to raise rates again? Thanks to your thinking, you have to be a multi-millionaire to survive on return on investment now. There cannot be any future with this kind of game.

2008 Jan 25 09:32 AM

[Congressman:]

I say we raise interest rates to 20%, save the dollar, bring on the recession...err, i mean depression and get it over with. Besides, I missed the window to buy gold...I'd like the Fed reserve to deflate the price of gold back down to the 200-300 dollar range so I can begin investing in it for the next big bubble economy 10-15 years from now.

2008 Jan 25 12:27 PM

[Zeppelin:]

Let's have a Dollar Devaluation day. Print tons and tons of a new AMERICAN Currency and move it to the Financial Institutions. On a given Sunday, we cut everything 90%. Our pay, Gas, Food, EVERYTHING. Any bills owed, cut 90%. Then we can compete with the "Emerging" Countries. Go backwards in time to 1960 levels. Then we can sell our goods overseas and make a Killing. Start from scratch... Zat will pizz off the Rich and Incompetent for creating this mess...

2008 Jan 25 02:19 PM