Fed Funds Flattened

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The Lehmann Letter ©

Today the Federal Reserve reduced its federal-funds-rate target to between 0% and ¼%. You can read the Fed’s press release at:
http://www.federalreserve.gov/newsevents/press/monetary/20081216b.htm .

Direct your attention to these key passages:

“Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further……

“The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time…….. “

The patient is in intensive care and the Fed is administering its strongest medicine. Will it work?

We’ll see. The Fed’s efforts are certainly superior to maintaining high interest rates in the face of the economy’s collapse. But will rock-bottom interest rates actively promote recovery?

During the 2000-2002 dot-com bust the Fed also promoted interest-rates’ decline. Fortunately housing and autos responded favorably to these cuts, remained strong, and then blossomed by rising to sustained levels not seen before. Unfortunately we know how that story ended. Housing collapsed under its own bloated weight and dragged autos down with it. Falling interest rates have not yet resurrect these key sectors.

During earlier business cycles, in the 1960s and 1970s, a surging economy – booming housing and autos - ignited inflation and rising interest rates. Higher prices and higher borrowing costs choked-off the boom – slumping housing and autos - and led to recession. But these slumps were self-correcting because recession’s depressed conditions reduced inflation and interest rates, thereby reigniting – housing and autos - economic growth.

The economy behaved like a frisky horse in these earlier cycles, charging ahead when the reins were dropped and coming to a dead stop when reined in.

Today the reins are dangling to the ground. Inflation has disappeared and the federal-funds rate is negligible. Will the horse once again feel his oats?

Stay tuned. There are reasons to believe that this time is different because the bursting of the housing bubble has no analogy in earlier recessions. No one pulled back on the reins this time. Instead, the horse ran himself ragged. It will take a while for him to regain his strength.

© 2008 Michael B. Lehmann