NEW YORK (CNN/Money) -
The Fed is going to cut by a half point? Oh, please.
Sure, you can spin all kinds of reasons why Alan Greenspan and his merry bankers would want to be so aggressive. It would show that they are in an all-for-one-and-one-for-all fight to save the economy. It would show that when it comes to the threat of deflation, they're not going to pussy-foot around.
It would, in the words of that supposedly in-the-know reporter over at the Washington Post (did we say "oh, please" yet?) serve as an "exclamation point" to show that Fed officials really believe their work is done and now the economy is going to recover. Because all of us have such faith in the Fed's ability to forecast the economy.
No, the Fed is going to lower the fed funds rate by a quarter point, from the current 1.25 percent down to 1 percent. And it's going to let the market know that it could drop rates again at the drop of a hat. And the reason it's going to do this is that, perversely, it will be far more stimulative to the economy than cutting the rate by half a point.
It's important to understand that the only rate that the Fed has any real control over is the fed funds rate -- the overnight rate that banks charge one another to maintain reserves at the Fed (okay, and the discount rate, but that doesn't matter).
Where the Fed sets the funds rate has some direct bearing on the economy. But really it is the level of longer-term rates -- Treasury and corporate bond yields and mortgages -- that does the economy's heavy lifting. And those long rates, while influenced by the current funds rate, operate more as a forecast of where the funds rate is going to be in the far-off future.
Long rates have come down massively since the Federal Open Market Committee last met on May 6. The reason? Although it didn't move on rates at the meeting, in the statement it released following the meeting, the Fed signaled that it was more worried about the prospect of deflation than inflation.
That meant the Fed didn't plan on moving rates higher until well after the economy has recovered, and that meant the future funds rate the credit markets were forecasting was too high. In the seven weeks since then, the yield on the 10-year Treasury note has fallen more than half a point.
By dropping rates by a quarter, and indicating that rates could fall again, the Fed can keep this dynamic working, ensuring that long rates stay low and thus keeping mortgage activity smoking along and bringing down corporate borrowing costs.
Couldn't the Fed just cut the funds rate by a half point down to 0.75 percent and leave open the possibility of further cuts? Unfortunately, no.
According to Credit Suisse First Boston bond market strategist Mike Cloherty, if the funds rate were to go below 0.75 percent, money market funds would begin facing severe strains, with some funds not even able to cover costs. Since their business model would no longer make sense, they might be forced to shut down.
Money market funds own about half of the commercial paper -- short-term debt that companies use to fund day-to-day operations -- outstanding. Just the threat of some of the money funds having to shut their doors would throw the commercial paper market into a tizzy, which would be incredibly disruptive to corporate America. Which is exactly what the Fed doesn't want to see.
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