4.25% Fed Funds?

On Larry Kudlow's show last evening, he had his cadre of ex-Fed guys all agreeing with him that because T-bills had dropped to 3.5%, that the real funds rate should be 4.25%. That misses the real point about why bills are at 3.5%. Investors are panicked, and in the past few weeks, it is more akin to game of musical chairs. Everyone not only wants a chair when the music stops, they want one made out of stone so that it doesn't collaspe when you sit on it. The problem is there aren't enough stone chairs to go around. For those of you that took and remember that microeconomics class, this is what those supply and demand graphs were referring to (Maybe the Treasury should take a page from the Bob Rubin school of government financing; stop issuing long bonds at historically low levels and push all the issuance into the front end). It has been said in this forum before, but this is part of the same liquidity problem. In this case, many investors want the same asset (bills) because they have no credit risk. Investors aren't going to start buying other money market instruments just because the funds rate is lower, at least in the near-term. The markets are finally getting around to working the excesses created by years of ignoring credit risk. A lower funds would help bail out (yes, bail out) the overlevered hedge fund and the guy in Podunk that took out mortgage he shouldn't have and couldn't afford.

The Fed should continue doing what is has been doing. It should wait and see the result of the discount rate cut, cut it again if necessary, and encourge borrowers to use this facility in this period of illiquidity. Once the supply/demand imbalance in the money markets has stablisized, then make a decision on funds. Barring some external event, it seems unlikely they would move more than 50bps.

One final note: A point that doesn't get much press is that is August and many of the risk takers and decision makers aren't in, especially in Europe. Even in the era on instant communication, it isn't the same as being at the desk.