You got that right, and now they are giving each other free money!
Free money
Commentary: Fed pushing real rate for overnight loans to zero
By Dr. Irwin Kellner, CBS.MarketWatch.com
Last Update: 9:59 AM ET Oct. 2, 2001
NEW YORK (CBS.MW) -- By the close of business on Tuesday, the Federal Reserve will be giving the banks free money with the hope of jump-starting the economy. See full story.
It may not be cheap enough.
The funds I am referring to are those that are borrowed by some banks in order to meet their individual reserve requirements. Banks that find themselves with excess funds at the close of each business day lend to those institutions that temporarily need them.
This activity takes place through the auspices of the Federal Reserve, which tightly controls the cost of these funds by buying and selling Treasury securities from and to a small network of dealers. Naturally, this charge is called the federal funds rate.
As recently as the beginning of this year, the banks were paying 6.5 percent to borrow money from each other overnight. With the underlying rate of inflation little more than 2 percent at the time, the actual cost of such borrowings to the banks was well over 4 percent.
This was the most expensive such overnight money had been since just before the onset of the 1990-91 recession. Little wonder why the economy was struggling toward the end of 2000.
Once the Fed realized that the greater threat to the economy was recession, not inflation, it reversed course and cut interest rates with alacrity. It reduced the federal funds rate from 6.5 percent on Jan. 2, to 3 percent by Sept. 17 - one of the swiftest declines in recent memory. See a recent history of the fed funds rate.
Although the weakening economy was bringing down the rate of inflation, the funds rate fell faster. This brought the real or inflation-adjusted cost of money - a better indicator of the stance of monetary policy - down as well.
But the real federal funds rate remained positive - until today. By cutting the fed funds rate for the ninth time this year, the Fed is in effect eliminating the real cost of such overnight borrowings.
Overnight funds rarely are free, in the sense that their cost is equal to or less than the rate of inflation. When they are, the economy is either in a recession or in extenuating circumstances.
Because today's situation is unprecedented in many ways, even free money might not be enough. Low interest rates have limited effect when people and business don't want to borrow and the banks don't want to lend.
If that sounds familiar, it should. This was the situation that developed in the 1930s, when the economy entered what came to be known as a "liquidity trap."
It took a massive dose of fiscal stimulus to get the economy moving forward again - just as it will today.
Dr. Irwin Kellner is chief economist for CBS.MarketWatch.com and the Weller professor of economics at Hofstra University.
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