FED CUTS RATES BY 50 BASIS POINTS: An Analysis

The Federal Open Market Committee of the Federal Reserve Board today lower its target for the federal funds rate 50 basis points to 1%. Yes, you read that right — 1%.

Click here for the Fed’s announcement.

The rate cut is first and foremost a statement on the predicament of the U.S. consumer. With their home equity sucked dry and banks unwilling to extend to them cheap credit, the U.S. consumer has simply stopped spending — and that’s got the Fed mighty nervous.

Whether it is officially declared as such, the U.S. economy is in a recession, and a recession negates much of the inflation risk normally associated with a fed funds rate of 1%. Remember, it is an effective inflation-adjusted rate of 0% that got us into this housing mess. But that was at a much different point in the credit cycle.

This is a waiting game. Namely, how long will it take for the federal government’s liquidity efforts to flower?

As Raymond W. McDaniel, chairman and chief executive of Moody’s Corporation, put it today during the company’s quarterly earnings call: “A range of global responses have been initiated to contain the damage. While we expect that these efforts will help stabilize markets, timing for recovery remains uncertain and has probably been extended.”

In a normal credit cycle, you could ballpark the duration of the trough or peak. But today all bets are off because the government is using such unprecedented means to extract the economy from its trough. No economics or history book will tell you how long it will take for a government infusion of capital into public banks in the form of preferred stock will lead to a revitalized banking industry — and it doesn’t matter whether the fed funds rate is at 1% or not.

Not that this 1% rate should be welcomed by banks. The nation’s remaining banks have reverted — or should revert, in my opinion — to a “trust” model, meaning that they are as “deposit takers” in an era of wild, 3.1% swings of the Dow in the last 12 minutes of trading (as was the case today). The problem is a 1% fed funds rate means less-attractive deposit yields, further limiting a valuable source of capital for banks, and just when they need the capital the most. But the Fed’s primary obligation is to the U.S. consumer, not the banking industry.

So the Fed lowers rates and waits as banks hope the markets stop gyrating like a drunken kangaroo. Heck, we’re all waiting for the cycle to turn. It is now about two years since the first cracks in the mortgage market began to appear to industry insiders. The government’s bailout efforts are remarkable, and I am certain at least some of the ramifications of those actions are well beyond our current expectations. It’s black-box time for the U.S. economy, and there is still some unsavory market news to come.