Is the Fed Bailing Out the Economy or the Banks?

That is the question that reporters covering the latest rate reduction should be asking. When the Fed announced its 0.5 percentage point rate cut this afternoon, something very interesting happened: long-term interest rates rose. The 10-year treasury rate jumped by about 5 basis point when the Fed announced its rate cut. The current rate of 3.72 percent is about 34 basis points higher than the low hit earlier this year.

There is a simple story that could be told to explain the movement in long-term rates. The markets may increasing fear inflation and a falling dollar when they see the Fed cut short-term rates. This raises a serious problem from the standpoint of stimulating the economy. The long-term rate matters much more for the economy than the short-term rate since it affects the rate that people will pay on mortgages, car loans and most other important sources of credit. If the Fed's rate cuts lead to higher long-term rates, then it is possible that it is actually slowing growth by cutting rates.

There is another story in which the answer is less ambiguous. Banks borrow short-term and lend long-term. If they can borrow at a lower cost and lend at the same or higher interest rates, then they are unambiguous winners. For them, a rate cut that increases the spread between long-term rates and short-term rates is clearly good news.

So, if this pattern continues, and the Fed moves forward with further rate cuts, then it is reasonable to ask whether it is trying to help the economy or the banks.

--Dean Baker

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