I have come to a new conclusion today: The Federal Reserve should not have the ability to control the overnight lending rate and the discount rate. Rather, these rates should be determined in the marketplace. This is certainly not an original idea, but it simply makes sense in today's global financial markets. The Fed should, however, maintain full control of banking regulation.
Yesterday was a great example of the power a small group has in controlling the destinies of millions of people. The markets were expecting a 50 basis points (.50%) cut in the Federal funds rate, which is the overnight lending rate banks charge each other. Instead the Fed delivered a 25 basis points cut. The logic behind having the markets determine this is that the market is made up of countless individuals - generally very smart people who are a lot quicker acting and thinking that the economists at the Fed. We already use the marketplace mechanism to determine the price of commodities, which includes food (wheat and milk for instance), oil, lumber, and metals such as gold. In fact, just about any commodity you can think of has its price determined in the market - it's not only about stock prices. And, we also have a market for predicting the Federal Reserve's moves - the fed funds futures market. And then, there is the bond market which determines interest rate on government lending - short and long term.
The problem with the current system whereby a small group at the Federal Reserve determine the rates is a lack of transparency. The marketplace is always trying to guess what the Federal Reserve's next move will be. The Federal Reserve, on the other hand, constantly watches the marketplace to determine what they should do, but often lags significantly or acts in a manner that is unexplained. Yesterday's move, for instance, was made under the guise of inflationary fears. I have news for the smart people at the Fed: there is no indication of inflation. People don't have money to pay their mortgages, and many are worried about their home values falling faster and quicker than ever. The consumer is weak - this is not news, even to the Fed. Higher oil prices have acted like a tax - taking away more money from people's disposable income. This has helped curb inflation, ironically.
If the overnight rates were determined by the marketplace, I believe that the current credit crunch would be a lot farther ahead in terms of being solved than at the current pace. The reason is that the markets are lot more dynamic and quick acting than the Fed, which only meets 8 times a year. The overnight lending rate would have come down at the beginning of the summer and the current elevated LIBOR rates would probably not have been an issue.
One way in which this could work is that the Fed would control liquidity based on the market rates. So, open market operations would continue as they do now, except that they would use the market determined rates as the targets and thereby add or remove liquidity accordingly.
I am probably missing a plethora of important technical details, but that's for the so-called experts to sort out. The basic idea is that we need a lot more transparency. The financial markets have become almost a bank for most Americans as most savings through various financial products, e.g. 401Ks, IRAs, and many others, are in securities whose prices are determined in the marketplace. These prices fluctuate dramatically when the Fed makes unexpected moves and hurts the very people it is trying to help. Simply put, to have an organization that is:
a) not transparent enough,
b) constantly lagging in its ability to react to the current economic environment,
c) has tremendous power in determining individual wealth effects and individual financial decisions,
is simply not acceptable in today's extremely fast moving global financial markets.
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