Why the Fed's panicky rate cut won't save the US economy

Seeing stockmarkets plummet across the world, the Fed has today slashed interest rates by 75 basis points, to 3.5%. Will the cut make any difference - and what does it mean for your investments?

Don't panic. It's the number one rule in a crisis.

But it seems that the people who run the global economy didn't read that particular rule book.

Seeing stock markets plummet across the world in the past two days, Ben Bernanke and his compatriots at the Federal Reserve arguably the world's most powerful central bank have today slashed US interest rates by a full three-quarters of a point (that's 750 basis points, if you want to get technical about it), to 3.5%.

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Here's what the Fed said to justify the cut: "The Federal Open Market Committee has decided to lower its target for the federal funds rate 75 basis points to 3 per cent. The Committee took this action in view of a weakening of the economic outlook and increasing downside risks to growth. While strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labour markets."

In other words, "we think there's a recession coming and in fact it may already be here." Nothing the stock markets hadn't belatedly worked out for themselves already, of course.

Now received wisdom suggests that changes in interest rates don't take effect immediately. In fact, most people think they take about 12 to 18 months to kick in. The Fed had just eight days to go until its next official interest-rate setting meeting on January 30th. Now perhaps I'm wrong, but in the context of a year, I don't think eight days would have made that much difference.

So what's the Fed trying to do? Well, the answer seems pretty straightforward. This is a huge, drastic move make no mistake about that. US interest rates have not been cut by this much in one go in more than 20 years. Bernanke is trying to make sure that everyone on Wall Street knows that he will do whatever it takes to keep share prices afloat. Particularly during an election year. And if that means destroying the dollar, or igniting inflation, then so be it. They don't call him Helicopter' Ben for nothing.

So what does it mean for your investments? Well, it's going to be interesting to see what happens to US stocks today. After all, the Fed has just unleashed a volley of shots from its interest-rate gun'. If the cuts don't work, there aren't that many shots left. And if you look at headline inflation, US real rates are now already in negative territory (in December, the consumer price index was up 4.1% on the year and even the core reading, which excludes food and energy cost, rose at an annual rate of 2.4%). That means that savers will almost certainly soon be losing money by keeping it in the bank. If that doesn't force consumers to spend, then there's not a lot else the Fed can do.

We suspect that the cuts won't work. Sentiment has turned and people and companies are now focused on rebuilding their balance sheets. Looser lending conditions will be used to repay debt, not to borrow more. One way or the other, the US is heading for recession, and rate cuts now only risk making inflation a real threat.

Of course, it's all good news for gold. Gold has sold off recently, almost certainly in part due to various players rushing to liquidate easily sold assets to fund losing positions elsewhere. It looked set to fall further today, but the Fed's announcement arrested the decline almost immediately. We suspect it will be back above $900 an ounce before too long.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.