Has the monetary policy reach its limits?
Written by A Forex View From Afar on Tuesday, November 11, 2008Futures markets are currently pricing in at least a 25 basis point rate cut at the next Fed meeting, which will be held 16th of December.
However, is there a real need for another rate cut? In order to answer this question, we first need to know exactly how the Fed works.
The Federal Open Market Committee, or FOMC, meets eight times a year to adjust the bank’s monetary stance. At these meetings, the FOMC sets the Targeted Fed Funds Rate, which is currently set at 1%. From the last sentence, the word “targeted” should be noted, because the FOMC only sets the target, which should be achieved in the inter-banking market.
The nominal rate or the real rate at which banks make overnight loans is called the Fed Fund, which is now running at 0.27%, a historical low, and at the same time, way below the targeted rate. More accurately, the spread between the target rate and the effective rate is one of the biggest on record, these days.
The question that now arises is ‘how much would the real economy benefit from another rate cut given that the spread between the targeted rate and the effective rate is almost 75 basis points?’ Another rate cut will reduce the effective rate by a few extra points, but it would still not match the 25 basis point cut in the targeted rate.
From this point of view, it seems the inter-banking market has fully priced in a few rate cuts. This means that another rate cut will have a very limited impact for the real economy, since the effective rate is so low. We are experiencing the limits of monetary policy and this is a strong sign the government should enact another stimulus/bailout plan rather quickly, before the Fed runs completely out of power.
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