The Federal Reserve and other central banks around the world cut interest rates this morning for reasons that are obvious to everyone. Normally, we’d criticize the cut, given the sea of liquidity already flowing from the world’s central banks. But these are not normal times, nor is it clear when normality, or something approximating it will return.
One indication of the abnormality is the rapidly fading threat of inflation, at least for the short term. With the credit crisis becoming materially worse over the past month, the idea of generally higher prices is on holiday until further notice. Disinflation if not deflation is the bigger risk for the time being, which gives the Fed and its counterparts around the world more room to drop rates. (The Fed’s cut was 50 basis points, which brings the Fed funds target down to 1.5%.) But while the evaporation of inflation risk provides some monetary breathing room, it’s also a sign of trouble in the global economy. There are several ways to mute inflationary pressures, but what we’re experiencing now is the worst of all possible ways to achieve that otherwise sound goal.
The immediate question is how much help will a rate cut bring to the frozen credit markets? The pressing goal is convincing financial institutions to lend. Today’s rate cut will help, as will the various efforts announced by the Fed in recent weeks. But the prospect of a quick turnaround in lending is dim, at least for the moment. Confidence has been shaken in the belief that loans will be repaid in a timely manner, if at all. Repairing that battered sentiment will take time, and a 1/2-point rate cut, while helpful and warranted, is only a small part of the solution.