Why the Fed cuts haven't worked

• Hiring holds steady
• Half of 'rescued' borrowers still default
• Job outlook gets gloomier
• Where the jobs are
• Where the jobs are

Issue #1: America's Money - Everyday on CNN

NEW YORK (CNNMoney.com) -- It's been almost a year since the Federal Reserve issued the first of what turned out to be seven rate-cuts to deal with the credit crisis.

So why does the economy still seem like it's in a big funk, with banks continuing to suffer?

One of the biggest proponents of the Fed's aggressive rate-cutting spree has an explanation.

Eric Rosengren, president of the Federal Reserve Bank of Boston, said in a speech Wednesday that the low federal funds rate of 2% is providing "much less stimulus...than it otherwise would" because of the credit crunch.

The federal funds rate is an overnight bank lending rate that banks charge each other to borrow money. But Rosengren argues that just because banks are charging each other a relatively low rate, this does "not necessarily translate into lower costs to the vast majority of borrowers."

In other words, even though the Fed has slashed the federal funds rate from 5.25% to 2%, many beaten-up banks have nevertheless substantially tightened credit standards for businesses and consumers.

Rosengren said that the rate cuts have "merely offset the tightening in credit conditions created by the financial turmoil that began last summer."

Rosengren is not currently a member of the Fed's policy-making Federal Open Market Committee. But he was a voting member last year for three of the cuts, and also voted in favor of the surprise three-quarters-of-a-point rate cut at an unscheduled meeting this past January.

In fact, Rosengren could be considered one of the more dovish (i.e. in favor of lower rates) of the Fed presidents. He actually dissented with the Fed's decision to cut rates by just a quarter-point last December because he wanted a bigger reduction.

So it's interesting that he's now acknowledging that the cuts haven't worked. Still, Rosengren defended the Fed's strategy, saying that "credit conditions would likely be much worse" if the Fed had not acted.

But Rosengren's comments highlight a big problem facing the Fed right now.

Sure, the recent slide in the price of oil and other commodities - and the rally in the dollar - may give the Fed reason to relax a bit about inflation fears. The global economic slowdown that now appears to be taking place means that the Fed is highly unlikely to raise interest rates any time soon.

Yet, the Fed doesn't appear to have much wiggle-room to lower rates further if the economy weakens further or if more banks get into trouble.

Few expect that the Fed would want to inch closer to the historic lows of 1% reached in 2003 - especially since many blame the low rate for the housing bubble.

In addition, with inflation as high as it is, further reductions to interest rates would hurt savers even more. Rate cuts tend to lead to lower yields on money-market accounts, precisely the type of investments that people might want to flock to in an economic environment as uncertain as this.

That's all the more reason to expect the Fed to keep rates on hold for the next few months, and instead continue to rely on more creative ways to end the credit crunch, such as opening up the so-called "discount window" of funding to investment banks and creating the Term Auction Facility short-term lending program to provide even more liquidity to banks.

So, simply put, investors and consumers probably have to sit tight and wait a while longer before lower interest rates will have an effect. Rosengren said that "as financial headwinds subside...we will see the rates available to businesses and consumers decline, helping to stimulate demand."

But it's anybody's guess as to when those headwinds will finally subside to a large enough degree to allow the Fed's rate cuts to work as they should.