Sunday, November 2, 2008

Why Rate Cuts (probably) won't work (fg)

In all likelihood, the FED will cut the federal funds target rate further to realize the rate to jump below 1 percent. Bernanke, working hard on the lessons of the Great Depression and monetary transmission mechanism, is prepared to do everything what is necessary to prevent the US economy to slump into a severe recession. To him, further rate decreases and a zero-interest-rate policy in the tradition of the BoJ will likely support financial industry and goods markets. Nouriel Roubini, the star of all worst-case scenarios, recently warned against a global stag-deflation. This possible effent would indeed urge the FED to let market rates fell further.

The scetched analysis has, in my view, at least two pitfalls.

1) Deflation sceanario
2) Effectiveness of monetary policy

@ 1) I cannot see that there is a real danger of deflation. Negative economic growth might be on the agenda the next quarters across the globe. However, unlike during the Great Depression, real money growth is still robust. The reverse was true at the beginning of the 30s, where the gold standard pushed monetary authorities to high and volatile interest rates which triggered a decline in real money growth. There are no signs indicating to such an event. In Europe, to put it exaggeratedly, higher wage demand would also support a non-deflationary environment (but a negative impact on industrial production).

@ 2) Monetary policy might not work through the transmission mechaism effectively. The two figures illustrate this point. Both, US Treasury rates and the feds funds rate declined rapidly over the last months due to recession risks. However, we see that U.S. coporate bond rates hiked dramatically over the same period. This might be the results of increasing default risk and signs of a credit crunch. The decoupling might force the FED to re-think its operations. Interest rate reductions might not prevent the financing of medium-sized companies to collaps. Consequently, if the aim is to (re)-act potent, the FED should conduct open-market operations directly in the corporate bond sector, i.e. buying commercial papers.