Why the Fed should not cut rates

Calls for Fed rate cuts are becoming more common. And maybe the Fed will cut the Fed funds rate when it meets tomorrow. But there are more compelling reasons for the Fed to wait.

Are rate cut calls well-thought out?
Calls for a rate cut are calls to cut rates in the middle of what has become a real crisis that has spread beyond housing to Wall Street. One problem with a cut at this time is that a rate cut will muddle the message. The Fed has been carefully compartmentalizing its policymaking under Bernanke. It has created special lending facilities to help with liquidity and this week, it has taken new action by broadening its various lending facilities. Will lower rates help? Maybe. But not by much and lower rates have risks and costs.

How rate cuts help:
Rate cuts do three-things. (1) They lower interest costs by the amount of the rate cut. (2) They lead to expectations more rate cuts that can cause market rates to fall by more that the rate cut itself. (3) A rate cut inspires confidence that the Fed will turn a troubled situation around and that the direction of rates is down again, for some period of time.

How rate cuts can backfire:
But rate cuts can backfire, too. And a cut in the middle of crisis does not inspire confidence that the central bank is prudent; rather that it is panicky. Moreover, in the current situation the Funds rate is at 2% and everyone knows the Fed does not want to cut it. Indeed, Feddies have been saying for months that the next move in rates will be up, What a terrible Fed-wide public forecast! Setting that aside, the problem is that a rate cut will not be deep, it might not inspire confidence of more to come and it may not cause people to think that the trend in rates is now lower. A cut may come to be seen as a one-off event and have a very limited impact. OR it could cause markets to have a widespread adverse impact. IF the Fed move is viewed as a move that is too hasty it could stop the trend lower in long term bond yields or result in a sell-off of the dollar.

To have impact, first get attention
If the idea is to take some leadership on the direction of market rates you first need to get the market's attention. It might be better to wait for when so much is not unraveling. IF you are training a dog, for example, and if you wanted his attention for a really important trick, you would eliminate other distractions first. The Fed cannot eliminate the distractions but it can pick it's spots. If it waited for things to calm down it later could cut rates between meetings and REALLY get our attention.

A reluctant Fed
While the Fed could cut the Fed funds rate to zero, we know it does not want to cut it below 1%. Indeed, we know it does not want to cut it any more at all. The Fed can cut rates but its not going to elicit much enthusiasm for markets to expect more.. Moreover, oil prices fell sharply, gold rose and the dollar fell on Monday. A hasty Fed rate cut could reverse what has been some nice strength in the dollar. Should dollar losses speed up, commodity prices could flare again.

If it don't work why do it again?
One thing we must admit is that the last rate cuts did NOT work and they cost us more in terms of weakening the dollar and boosting commodity prices. I'm hard-pressed to urge the Fed to try it again let alone in the maelstrom markets have become.

On balance a rate cuts seem to put more at risk than it promises to help right now. That could change but in this environment rate cuts are a double edged sword. Why take the chance?