I hope to get to your question later today, so bear with me. I have gotten very wound up about Paulson and am working on a post on the subprime rescue plan.

Anon of 4:03 AM,

Thanks for your kind words. Yes, I neglected to mention the Fed funds rate, and should have included it, particularly since it was negative real rates in the US that fueled our housing bubble. I am so tired of the focus on whether or not the Fed will cut that I wanted to put the focus elsewhere. But that doesn’t excuse at least an acknowledgment of the role of the Fed funds rate.

But it is fair to question, as you did, to what extent Fed fund rate changes are effective. 17 rate increases did little to stem the frothy lending and also has comparatively little impact on slowing growth ex-housing.

And in these circumstances, I am in the Nouriel Roubini camp. He pointed out that the current crisis is one of lack of transparency and insolvency. It isn’t clear at all that rate cuts will ameliorate the problems at hand. I wish the powers that be were thinking of regulatory solutions that would increase transparency. That might take more time to implement, but this crisis has been in motion now since August with little in the way of relief.

A more accurate and relevant categorization is that only measure of liquidity the Fed controls is the monetary base. Moreover, it doesn’t control the full monetary base. It only has absolute control over the level of excess bank reserves. It really has no direct control over the demand for currency from the public, to which it responds with a completely elastic supply function that it automatically funds as part of a growing monetary base over time.

Of greater relevance though is that the primary ‘thing’ or objective that the Fed controls is the level of the fed funds rate (trend, ex daily volatility) through the effect of its monetary base operations (open market, etc.).

Control of the funds rate is really the only operational reason the Fed has an interest in controlling the level of excess reserves.

The critical question is whether changes in the fed funds target rate from here will have an effect on monetary velocity and the use of ‘liquidity’ by banks. This is quite a different question than whether existing liquidity is being deployed effectively at the current funds rate (it isn’t), which greatly confuses the debate on the ‘pushing on a string’ issue.

Anyway, congratulations for being a member of an elite group of commentators that has some appreciation of the technical meaning of liquidity provided by the Fed. At least 99 % don’t.

Interesting points, as usual.

Do you think that, maybe, the Fed is just propping up every weak-handed player? And thus reducing overall confidence in the system, the precise opposite of what should be done?

The UK seems to be having a massive private contraction, probably not a shock to anybody who watched the Northern Rock imbroglio unfold. It’s not clear to me that the US is facing the same situation.

I am also coming around to the idea that Bernanke is simply inflating away the “global savings glut,” using this crisis as his opportunity to cut early and often, to correct imbalances which he perceives (correctly imho) to be unsustainable. But the stresses are already popping up elsewhere, from soaring Chinese inflation to lurching-apart spreads of European government bonds over bunds.

Comments?