Greenspan Fed Makes History

The numbers speak for themselves.

The Federal Reserve lowered the fed funds rate by 50 basis points yesterday to 2.5%, the lowest the rate has been since the recession of 1962. The discount rate was cut to 2%, the lowest level since September 12, 1958.

And the Greenspan Fed has now moved past the 1929-1930 Fed as the most aggressive in the institution’s 88-year history.

The 1929-1930 Fed cut the discount rate from 6% to 2% in 14 months, from November 1 1929 to December 24, 1930. The Greenspan Fed made the exact same move – from 6% to 2% – in 9 months, between January 3 and October 2.

If nothing else, the qualifier “largely symbolic” may finally be dropped from references to the discount rate. Discount window borrowing is when the Fed essentially acts as the lender of last resort, and banks borrowed billions via the discount window in the days after the September 11 terrorist attacks. There’s nothing symbolic about the rate when it’s needed.

The Fed has now flooded the financial system with billions in reserves and slashed interest rates below the rate of inflation. At some level and at some point, those actions will benefit the economy. Make no mistake about it, the Fed is doing what it needs to do.

But it’s not too soon to begin a serious discussion about deflation and liquidity traps. And the sooner that discussion begins, the better the outcome will likely be.

No one knows better than Net investors the fallacy of the statement, “It’s different this time.” No one has unfortunately ever found a way to repeal the business cycle, and this time has been no different. We’re not sure how many more parallels we need before someone sits up and notices the similarities between the current U.S. economy and the U.S. in the 1930s or Japan in the 1990s.

A quote from a must-read piece in Sunday’s New York Times Magazine by Princeton economist Paul Krugman:

“An already advanced nation pulls ahead of its first-world peers, taking the lead in all the hot new technologies. Stock prices soar to levels that look insane using conventional criteria, but everyone agrees that in such a dynamic economy old rules no longer apply. And then the bubble bursts, leaving behind a mountain of bad debts and an economic engine that refuses to turn over.”

Krugman was referring to Japan in the 1980s and 1990s, but the statement could also apply to the current U.S. economic situation. When central banks rely too much on interest rates to stimulate demand and regulate the economy, debt eventually becomes too great for interest rates to have much effect. We may be entering such a period now, and it’s not too soon to begin considering remedies that may be outside the central banker’s usual array of instruments.

Again, none of this may come to pass, and using commodity prices as a measure, we haven’t yet crossed the line from disinflation into deflation. But the sooner we consider the possibility that it might, the better the outcome will likely be. The Fed has already lowered interest rates to a level not seen since inflation began to take hold in the 1960s. It’s not out of the question that prices might follow.

The warning may sound a little dire, but the sooner it’s heard, the better. The Fed may already have done everything it needs to do to turn the economy around, but until evidence of that becomes clear, it would behoove policymakers to begin considering alternatives.

News Around the Web