Wednesday, October 29, 2008 2 comments ++[ CLICK TO COMMENT ]++

Federal Reserve Cuts Rates to 1%

FedRes cut rates by 0.5% today, taking the rate to Japan territory of 1%. I think this is a mistake. But the effective rate, as well as market expectations were for a rate cut, so the FedRes has little room to maneuver. Contrary to some mistaken views, the FedRes actually tends to follow the market rather than lead it.

The following chart shows the effective fed funds rate over the last 30 years. (Note that the effective rate is not the same as the target rate but it is the goal of the FedRes to perform open market operations to influence the effective rate. So for our purposes, it's almost the same as the target rate.)

As you can see from the chart, we have hit the levels of 2004. It should be noted that some, particularly the hard currency advocates, argue that the low rates in 2004 was what led to gigantic bubbles, not just in housing but also in junk bonds, emerging market stocks, commodities, art, collectibles, and many others. Although I think he puts way too much emphasis on FedRes actions, as Jim Grant would say, we are basically doing the same thing that put us in this mess in the first place.

The current rates are similar to the 40's and the 50's. I don't believe rates ever hit 1% in the early 1900's or late 1800's (but note that a US central bank did not exist back then and interest rates weren't quite the same.) The really big question, especially if you are macro-inclined, is whether this is going to lead to inflation. And if yes, then what assets are likely to appreciate.

Remember that even if you had correctly called the massive liquidity injections by Japan in the 90's, you may not have anticipated this capital flowing elsewhere. Right now, a lot of goldbugs, among others, expect inflation (particularly in commodities) but I am still not sold on that. If someone had called Japanese assets to appreciate, or even commodities there to increase in Yen terms, they would have been completely wrong. You would have had to anticipate the outflow of Japanese liquidity or else you would have suffered massive losses. In other words, you had to have called the Yen carry-trade. I do not expect a US$ carry-trade to develop since US assets are still attractive, and USA is still the most capitalist (large) country out there. However, it is a possibility that must be entertained. For instance, gold has been absolutely crushed in the last few months and the market clearly does not anticipate inflation.


2 Response to Federal Reserve Cuts Rates to 1%

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October 30, 2008 at 7:24 PM

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