Do the rules change at the boundaries?

Friends don't let friends cut interest rates too far
DON'T DO IT BENNY!!!

Fed to cut... Fed to cut...Not?
Everyone (except me!) is looking for the Fed to cut rates and maybe even eventually take them down to ZERO (zero, as in zero, zilch, nada - that zero). This is to be an example of how the Fed will go to any length to help the economy...Yeah, OK, I get it, but, is it a good idea? Is it like eating your young to stay alive or is it some other more acceptable 'demonstration' effect that shows your toughness? I'm not so sure of the signal here - that's my point. I think it's wrong to assume that the message will be 'Fed resolve to do whatever it takes.' Cutting rates is the EASIEST thing the Fed can do. Moreover, it carries with it dangers. Rate cutting loses its punch at some point. The closer you get to zero with the funds rate - and we're at 1% -- the less 'bang you get for the buck (or for the baisis point).' Perversity can set in and spoil your plans: at some point, rate cuts can deter you from your objective.

No one seems to want to make this argument so let me flesh it out...

Perpetual Vacancies at the Roach Motels

• Rate cuts adversely impact those on fixed incomes like retirees.
  
• Right now instead of cutting rates, affecting SPREADS would be a more effective thing to do to help the economy. Spreads are wide while rates are low.
  
• A lowering in short term rates usually just steepens the yield curve and THAT is not a way lower long term rates such as mortgage rates. Presumably we do NOT want to spur a NEW wave of mortgage refis into variable rate products, but further rate cuts certainly will make that road seem attractive. So this draconian rate-cutting is a mixed message. The Fed wants banks to lend to the housing industry but not lend via more of those risky ARMS when rates are so low that we know rates are going to rise (like from 1% or from ZERO- duh!). We don't want people 'barely qualified as buyers' or for refis' on rates too low to stand the test of time. Yet, here we are again! Or maybe this is the Fed's closet relief plan for besieged mortgage holders?
  
• Banks borrow short and lend long. So cutting the Fed funds rate will lower the banks' cost of money and increase their returns and profitability. It is yet another step to help banks, the new roach motels of the financial markets (rate cuts go in...and they don't come out!).

Fed cuts: the way they do the things they do...
When the Fed cuts rates it impacts market rates two ways (1) the level of official rates is reduced, putting downward pressure on market-determined rates, and (2) expectations for future rates usually encompass expectations for future cuts adding more pressure to reduce market rates...unless the Fed is at the end of the line for rate cuts.

Signal for the end of the line... One if by land, two if by sea?
The signal for the end of the line is not some clear message from the tower of the old North Church. It largely comes after the fact and so is less a signal that warns than it is a diagnostic that tattles, saying 'you went too far.' The message is given when the Fed cuts the FF rate and longer term market-determined rates rise instead of falling. Uh, oh... Already in this cycle despite all the economic weakness you have monetary base accelerating sharply and some are concerned about the 'eventual' impact on inflation. Uh, oh... Bond yields may have 'MAY HAVE' hit their lows, already in this cycle on the perception of economic duress. Those lowest rates have not held in place. Uh, oh.... That would leave this rate cut by the Fed sending nasty market signals down the line. (The Fed THINKS rates should be lower but the markets disagree...uh, oh...). Now some will argue that a whiff of inflation is just what we need. Some will, I won't. Since rates can't go below zero, the Fed has to be prepared somewhere along here for backlash. And if that happens the Fed will have lost control. And that is really scary. The real trick is to STOP BEFORE THAT HAPPENS. STOP NOW!

More rate cuts??? PLEASE FED DON'T GO THERE! The dollar already is slipping. Gold has stabilized. There are signs that financial market participants are no longer drinking the central bank's Kool-Aid. Yet, in the real sector, no manufacturer believes it has pricing power, or will it anytime soon. The consumer has been decimated. His asset holdings are trashed as the recent Fed-release on flow-of-funds shows us. It's as though markets are now fearing a pure monetary induced inflation not a demand-pull inflation. A rate cut could put the FED in the worst of 'both worlds' where cut's don't do you any good but instead tear down central bank credibility. It's like being in the Middle Ages and believing -really believing - in BLOODLETTING - it hasn't worked? What? Hey! Let's do SOME MORE!!! DONT' GO THERE, BEN!!

The monetary horror story
Yes, this tale is worse that Freddie, Jason, zombies or vampires - or even the return of Brittany! Worse, because it is a real possibility and a real threat. The horror story is that you spook financial markets about inflation before you convince real sector players that inflation is coming. In that case you get all the financial distress with none of the real sector push. Financial sector distress that appears in response to fears of inflation would occur because the Fed lost control over rates. Fed rate cuts would no longer bring market rates lower; indeed market rates might rise all the more sharply, fearing MORE inflation in the period ahead as the Fed gets to be 'too accommodative.' Already the dollar has stopped rising. Gold has stopped dropping and instead has been firming... Even OPEC is trying to cut production to prop up oil prices. But in the real economy no one fears inflation or thinks they will have 'pricing power' anytime soon. So there is no kick to the real sector. This is the WORST OF BOTH WORLDS. Please Fed DON'T GO THERE!!

So do things change at extreme points? What happens to water when it gets really, really cold? Ever heard of ice? ...Or when it ges really hot? Steam? Then there is the story about the Lone Ranger and Tonto to consider:

From Kimosabe to Chemotherapy...
The Lone Ranger was always referred to as Kimosabe (roughly, 'he who knows') by his wise native American sidekick... but what if Tonto ('tonto,' a name suspiciously like the Spanish word for 'stupid') were to be less like a a trusted friend and more like, well, a cancer? Could it happen?

The Lone Ranger and Tonto at the boundary: The Lone Ranger and Tonto were pinned down at the edge of cliff by a band of hostile 'Indians'. Try as they might they could not punch a hole in the perimeter and escape. Eventually they ran low on ammo. When the Lone Ranger got down to his last silver bullet, he turned to Tonto and said, "My old friend and faithful sidekick, we have been through a lot together and I guess this is the end of the line, for us. I guess we will have to finally admit defeat." Tonto, turned to the Lone Ranger and replied, " What do you mean 'We', White Man?"

Sometimes 'at the boundaries,' things change.