A cut in the Federal Funds Target rate today would be a pointless and possibly counterproductive move. Global financial markets are experiencing a renewed liquidity crunch. Some leading financial institutions, including global insurance giants like AIG, need large injections of new capital.
The liquidity crunch is best addressed by central banks making liquidity available on a large scale. In the US we have already seen a widening of the range of eligible collateral at the discount window. We will no doubt seen further relaxations of collateral requirements at central bank discount windows, in open market operations (repos) and at the range of ad-hoc facilities that have been created since August 2007. In the UK, the plans of the Bank of England to close the Special Liquidity Scheme to new business in October will have to be shelved, unless the SLS is at the same time replaced by an equivalent (or more comprehensive) set of arrangements. The central bank as lender of last resort and market maker of last resort is what is needed today, making funding liquidity and market liquidity available on a large scale and on terms that ought to ensure a profit for the central bank.
A cut in the risk-free short nominal interest rate is just not relevant under current circumstances, and would look, once again, like panic football. When the dust settles, there will be time to rethink the path of the official policy rate, in the light of what the fall-out from the panic implies for the macroeconomic objectives of price stability and sustainable growth.
If systemically significant financial institutions need capital and cannot get it in the markets, there may be a role for the Treasury. Capital injections by the state, through the Treasury should be expensive for the receiving party – financially and in terms of oversight and regulation. The Federal Funds target rate is completely irrelevant to the resolution of the capital needs of firms like AIG.
The knee-jerk calls for a Fed rate cut by part of Wall Street and its claque whenever something unusual hits the fan must be resisted if the Fed is to come out of this crisis with its credibility intact.