The Law of Supply and Demand. Force a price to be too high, and demand will slip, creating a surplus. Force a price to be too low, and demand will exceed supply, creating a shortage.
By aggressively cutting rates, Bernanke is lowering the price of money. That’s supposed to stimulate demand and help the economy pull out of its nosedive. The problem is, that works in theory but not as it applies to our current crisis.
Fed rate cuts won’t stave off this correction because the economy was never suffering from a lack of demand for borrowed money. On the contrary — the problem is that the banks got spooked by rising defaults in mortgages and cut off the supply of cash. The evidence of that is how much mortgage rates have risen, even as Fed rates have plummeted.
The banks have been acting quite rationally for companies faced with the potential of significant losses. Although the Fed has been lowering rates, banks have been tightening standards and reducing their willingness to loan money.
When the supply of a thing decreases, the price for it should go up. Bernanke seems to think that the solution for the credit supply shock is in cutting the price. As a result, the rate cuts won’t spur the economic growth many hope for. They will further weaken the U.S. dollar and bring on stagflation.
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