More Doom and Gloom from Mr. Bloom...

Today, the Federal Reserve cut the Fed Funds rate from 3.00% to 2.25%. That's a big drop. I'm used to the old Greenspan days where the cuts and increases were done moderately, in 0.25% increments. This all at once approach has me thinking that the folks behind the wheel, mainly Ben Bernanke, has no clue what he's doing and he's being reactive rather than proactive with respect to the economy.

So I suppose I took more business classes than most of you did, so let me try to explain what this drop in interest rates means immediately. The Fed Funds rate represents the rate which the Federal Reserve charges for their loans to other financial institutions for overnight loans.

Overnight loans are very important to financial institutions because the Federal Reserve requires that financial institutions maintain a certain percentage of their assets in reserve. The assets of financial institutions are always in flux because some people will make deposits (giving the institution more money) and some will withdraw their funds (taking money from the institution) while the institution creates loans for its customers and those customers also pay off their loans. If, on any given day, the institution makes a few too many loans and a few people withdraw a larger than expected amount from their accounts, the institution's reserves may drop below the level which is mandated. That's when the institution takes out an overnight loan from the Federal Reserve. The amount is paid off in the morning, along with the night's interest, and the institution goes about its business.

Making the Fed Funds rate lower means that it costs the financial institutions a bit less in interest every night, so if they think they can get a better return on their money by lending it out, they'll lend more and more of it, thoroughly depleting their reserves. But that's okay because they can always cover their reserves with an overnight loan from the Federal Reserve.

Lowering rates increases the liquidity of a financial institution, allowing people like you and me to increase our debt.

Now here's the catch... By lowering rates, more institutions borrow more money from the Federal Reserve. The Federal Reserve, however, doesn't actually have to directly worry about its level of assets, because if it needs more money than it has, it just prints more. That's right, this is the same Federal Reserve as is printed on the face of your Federal Reserve Note, which you happen to call a dollar bill.

So as the Federal Reserve prints more money to allow financial institutions to be more liquid, two things happen:
1) The amount of money circulating in the economy is increased, and
2) Financial Institutions are incentivised to lend out as much of their money as they can to receive as much return as they believe they can get.

Item 1 results in inflation. Item 2 results in assuming more risk.

Inflation and risk are not what this economy needs, right now. Raising rates simply prolongs the existing economic issue so that we'll have to deal with it later rather than sooner.

But we will have to deal with it. The only question is "When?"