The Fed may be playing a dangerous game in the financial system given their recent flamboyant monetary policy.

We’ve all seen the significantly aggressive ease in monetary policy adopted by the Federal Reserve which was illustrated by their 125 basis point cut in the Fed funds rate along with cuts in other formal rates such as the Discount rate, all in just about two weeks time.  The defenders of the extreme action justify it in light of the weakening economy and probably more on the heels of the profound weakness in the Equity markets.  Some of the logic behind cutting rates includes the idea that reset rates for mortgage structures such as interest only loans may be more manageable, also lower rates generally frees up money in the system for individuals and businesses to borrow and finally, low bank rates sometimes cause individuals to shift money out of savings in such instruments as CDs and allocate more to other investment opportunities such as Stocks and real estate.

This all sounds positive, but there is a major problem that the current level of short term rates may encounter, and that is a shortage of funds in the banking system.  The current level of the Fed Funds rate and the rates almost across the entire Yield curve are registering negative real interest creates (e.g. interest rates that do not cover the increase in prevailing inflation) so as an investor or saver, this does not offer an attractive investment option.  The banking system operates on the fundamental that deposit balances from those who save are used to create loans to those who borrow.  Financial institutions are finding it difficult to maintain robust dollar balances which serve as the foundation for making loans.

Yes, cutting interest rates in extraordinary fashion may help the short term plight of Stock markets and may drop mortgage rates, but the medium to long term affects could be quite negative, especially in light of the current situation in the financial system.  This bubble creating mentality, by creating a free money environment, may just backfire as banks seek to maintain a stable deposit environment.