When You Wish Upon a Star...

Apropos of my last post, Greg Mankiw doesn't want a pony for Christmas; he wants a unicorn:

Here is one idea. Suppose the Fed cuts the federal funds rate once again to, say, 25 basis points. More important, at the same time, the Fed announces a target path for the price level as measured by the core CPI. The price path might be, say, an increase of 2 or 3 percent per year. The Fed promises not to raise the fed funds rate over the next 12 months and, after that, will keep the funds rate at that low level as long as the price level is significantly below its target path.

The credibility of the promise is paramount. To get long-term real interest rates down, the Fed needs to convince markets that it will vigorously combat deflation, and that if deflation happens in the short run, the Fed will reverse it by subsequently producing extra inflation.

In at least one way, Mankiw is wrong: the credibility of the promise to fight deflation isn't paramount. What is paramount is an assured belief that the Fed actually has the ability to effectively fight deflation. At this point, that proposition look tenuous at best, laughable at worst. And so Mankiw concludes:

That's where the prayer part comes in.

All together now: There's no place like home. There's no place like home.

Pushing On a String

The Fed cuts the funds rate by 50 basis points, down to 1%. But at this point who really cares? This is becoming akin to a zen koan, or a Douglas Adams novel:

Q. I know the normal effect of monetary policy in normal times, but what effect does monetary policy have in the context of a massive TED spread, nationalized banking systems in the most liberal economies in the world, and rapidly-expanding currency crises throughout the emerging world?

A. 42

I mean, I guess a cut couldn't hurt, but it still seems like a non sequitur. Oh well. Don't panic, and don't forget to bring your towel.

Financial Contagion?

Iceland is near bankruptcy. Credit crisis hits Canada. Belgium, France, Luxembourg intervening to save bank after bank. The Euro falls to 14 month low as credit crisis spreads throughout Europe. Asian equity markets continue their deep slide.

$700 billion bailout. 50 basis point emergency global coordinated rate cut. Banking deposit guarantees. Governments taking equity stakes in banks (yes, including here in the US). 

Is there any further action that can stem the spread? Can the government do anything? Is this too little too late? Is a global recession inevitable? 

More Overnight/Early Morning Developments

The Federal Reserve, along with the European Central Bank, the Bank of England and the Swiss, Canadian and Swedish central banks enacted, a coordinated, emergency cut in their benchmark interest rates early this morning. This comes in response to massive stock market declines in Japan, Russia, Indonesia and many other global indexes overnight along with further market interventions by European governments and central banks to prop up failing institutions, as Tom observed. The cut's timing also shows the urgency of central bank officials attempting to stem the fear of the aforementioned developments from further battering European and American markets during today's trading.

This is purely and clearly a psychological move by the world's central banks. Something needed to be done, in a coordinated way, to show the markets that the central banks were ready and able to intervene to stem any remote possibility of global financial collapse and the central banks believed further liquidity was the answer. But the problem is not liquidity, its confidence. How lowering a target rate that does not actually really matter (check out the data on the effective FFR over the past 3 weeks), will fix the problem, I can not see. Lowering the target as a purely psychological tool to attempt to impact investor confidence, may have an impact. How much of an impact and will the impact be enough? I have no idea but, I guess we'll see.