The Mysterious FED Actions

Robert Barro e-mails Greg Mankiw to let him know that the effective FED funds rate for the month of August was 5.02%, or 23 base points lower than its declared target. I knew this was going on, but I hadn't see the official numbers. (At one point, I'd read that the funds rate was 4.88%, but I didn't realize that it was under 5.25%, on average, for the whole month). There are several ways of interpreting this.

1. The FED wants to tell the markets that it is serious about controlling inflation, so it hasn't yet changed the official rate. But it also wants to tell the markets -- and especially the big bankers -- that it is serious about preventing a credit crunch, so it has given itself a lot of flexibility to deviate from the official rate for short periods of time.

2. The FED can't effectively control the funds rate anymore.

3. The FOMC has become unhinged from the FED board of governors.

4. The FED is preparing for an official rate cut this fall, but didn't want to wait until then to quiet the markets and ensure short-term liquidity.

5. The FED is not preparing for an official rate cut this fall, but didn't want to freak out bankers who were already concerned about a lack of liquidity.

6. The FED wanted to signal to some key players in the economy (e.g. big bankers) that it would help keep the ship afloat, but didn't want everyone to become too expectant of the FED to come bail them all out, so it allowed the effective rate to temporarily drop.

7. A temporary effective decrease allowed the FED to postpone a decision about whether or not to officially lower the funds rate until a later date, while they got more information about the overall state of the economy and watched to see the extent of the subprime meltdown. All this without committing to any substantive action.

I think that #s 1, 6, & 7 are extremely likely; #s 4 & 5 are fairly likely, and one of the two (but not both) are likely true; #s 2 & 3 are extremely unlikely. But I could very easily be wrong about any and all of this.

Update: Megan McArdle hopes that the FED is just fooling us, but seems to place a much higher probability on the possibility that the FED has lost control of monetary policy than I do. For the most part, I'm operating under the assumption that the FED knows what it's doing, knows what it wants to do, and is able to execute that strategy. But it is a possibility that monetary policy has become unhinged from typical controls. That would be very, very bad. I don't think that's happened, but it is possible.