This article first appeared in the St. Louis Beacon: October 29, 2008 - The Fed's decision to again lower its federal funds rate will not prevent an economic downturn. In fact, this move will cause even greater problems when it decides to wean the economy from its cheap credit policy.
Lowering the federal funds rate to 1 percent is eerily reminiscent of the Greenspan Fed. In 2003, the Fed aggressively pushed rates to then-historic lows because banks wouldn't lend. In the post-9/11 world, banks were too uncertain to make loans, and borrowers too uncertain to seek them. To break this credit logjam, the Fed lowered the price of credit and kept it there for several years.
That policy and the government's push to increase home ownership among disenfranchised groups are the genesis of our current problems. That policy mistake, more than any lack of regulation, will be studied for years by students of central banking as an example of what not to do.
Why mimic past policy mistakes? Some believe that the Fed's latest move is the correct one. With credit markets frozen tight, this view goes, lowering rates gives lenders the incentive to makes loans. With credit so cheap and with the Treasury so willing to provide funds, why not get back into the lending game?
The problem with that view is that some of the nation's largest banks are not interested in lending. They'd rather use the government's largess to grow bigger. For example, the $5.6 billion purchase of National City by PNC Financial Services Group Inc. represents using Treasury money for acquisitions rather than making loans. I guess Treasury's backing of bank consolidation is buried somewhere in the 400-plus pages of fine print. Is that what Treasury Secretary Henry Paulson meant when he urged passage of the bailout so Treasury could recapitalize banks?
PNC's action apparently isn't unique. A JP Morgan Chase employee conference call overheard by Joe Nocera of The New York Times reveals that it also plans to use the Treasury's money for acquisitions, not for loans. The unidentified executive noted that Chase's $25 billion of government funding would make it "a little bit more active on the acquisition side or opportunistic side for some banks who are still struggling." Regardless of how low the Fed pushes rates, banks like Chase and PNC are looking to grow, not lend.
The other side of the story is that capital markets have not frozen tight, as many suggest. Boring as it may sound, if one digs into the data on bank lending, you find that loans are being made. This point was recently made by a study by the Federal Reserve Bank of Minneapolis that looked at lending data. It concludes that credit markets continue to function. Bank credit for all U.S. commercial banks, an aggregate measure of bank assets less vault cash, has shown no signs of a nosedive. Loans and leases made by banks have not fallen off the edge. Commercial and industrial loans haven't declined precipitously during recent months, either. The bottom line: Banks have continued to lend to nonbank businesses and individuals.
If lending has not stopped, can lowering rates have damaging long-term effects? Yes. Reserves in the banking system are about 250 percent greater compared with their July level. When those reserves find their way into loans and the money supply, there will be a significant upward pressure on inflation.
The Fed is in a corner. When the Bernanke Fed decides to unwind this massive build up in bank liquidity, it will have to raise rates dramatically. If this switch occurs before an economic recovery is well under way, the public outcry will be deafening.
Rik Hafer is distinguished research professor and chair of the Department of Economics and Finance and director of the Office of Economic Education and Business Research at Southern Illinois University Edwardsville.