FOMC Holds Line at 2% Fed Funds Despite AIG & Lehman Crises (Full Statement & Analysis)

By holding the bank-to-bank Fed Funds Rate at 2% and the Fed-to-bank Discount rate at 2.25% at their FOMC meeting today, the Fed proved that the financial storm that’s been blowing since August 2007 requires much more than rate cuts. It’s not so much about the price of money right now, but rather the availability of money companies need to help them navigate markets as they go through the painful process of de-levering. What companies are going through right now is akin to a leveraged homeowner who cut back on work hours for personal reasons but is expecting a decent bonus at the end of the year, so he still wants to keep current on his mortgage payments—he just needs some help and if someone can provide some cash for the short term, he can continue to make his mortgage payments and can then repay this short term loan at the end of the year.

Likewise, instead of cutting rates further, the Fed would prefer to make short term loans to companies who need some time to settle short term obligations and can demonstrate good collateral to put up and future income that will reimburse those loans. This is the Fed’s strategy right now as indicated by their refusal to cut rates further … and this is the right approach. A simple rate cut is just not enough, especially when inflation adjusted rates are negative, further rate cuts would be inflationary and actually cause consumer rates to rise.

Comparing the 2% Fed Funds Rate to this morning’s year-over-year August CPI of 5.4%, inflation adjusted rates are -3.4%. Even if you use the 2.5% CPI number that excludes food and energy to compare to Fed Funds, inflation adjusted rates are still -0.5%. If this keeps up or the Fed cuts and it gets worse, you create inflation. Bonds hate inflation so they sell off which pushes bond yields up, which pushes consumer rates up.

All voting members of the FOMC voted to hold, this was the first time since the cut cycle began last year there was unanimous agreement on the rate position. Previously either Philadelphia Fed President Charles Plosser and/or Dallas Fed President Richard Fisher had voted to hold rates instead of cutting because of their belief in the inflation problem discussed above. Now we have agreement that tactical cash measures are the more effective tool. New York Fed president Timothy Geithner was absent because he’s working on the AIG crisis situation so NY Fed first vice president Christine Cumming voted in his place.

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

Strains in financial markets have increased significantly and labor markets have weakened further. Economic growth appears to have slowed recently, partly reflecting a softening of household spending. Tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Ms. Cumming voted as the alternate for Timothy F. Geithner.

PIMCO is buying mortgage bonds and right now they are arguably a more attractive investment than Treasuries because, like Treasuries, they’re backed by the government but they’re collateralized by property and they have a higher yield.