Flying Pink Unicorns

Federal Reserve to cut rates this week

The Fed is meeting this week to set short term interest rates. They will cut interest rates by half of a point, to .5%, from 1%. I support this cut.

Several months ago, I worried about the fed running out of room to cut rates, that is running out of bullets. Given that the economy is in a very deep recession (see my previous post) financial markets are still very deeply troubled (I have heard that the markets are pricing in a huge record number of defaults by investment grade companies, and an absurd 75% default rate in junk bonds (even a depression lasting 3 years probably wouldn't result in that bad of a default rate)) I'm not worried about holding ammunition in reserve anymore.

A better argument against a big interest rate cut now is that it won't do any good now, while credit markets are frozen, but might do some good in the future, when credit markets have again reopened. And there is merit in this argument. But a better argument is that low, or even zero short term interest rates, allow banks to cheaply build up their balance sheet by borrowing at short term rates, from other banks, and lending out money risk free to Uncle Sam. Even though long term rates are also very low, they are not zero, or 1%. Instead, the 10-year treasury bond is at 2.52 as of now. Borrowing short and lending long is what banks do in general, and allowing them to profit sharply from doing so is good policy right about now.

There is open talk of the fed simply cutting short term rates to zero (literally free money). My guess is they'll only cut to .50 %, but the difference is really only one in degree.