The Worst Recession in 25 Years?

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On September 18, the Fed cut its target for the fed funds rate by 50 basis points (0.5 percentage points), from 5.25% to 4.75%. The move surprised many analysts who had been expecting a more modest cut of 25 basis points.

For those versed in the Austrian theory of the business cycle, as developed by Ludwig von Mises and elaborated by Friedrich Hayek, the aggressive Fed "stimulus" is ominous indeed. Not only will it pave the way for much higher price inflation than Americans have seen in decades, but it will also exacerbate what could be the worst recession in twenty-five years.

How the Fed "Sets" Interest Rates

Before discussing the history of interest rate manipulation by the Fed, a primer will be useful. When people say the Fed did such-and-such to "interest rates," they are specifically referring to the Fed’s target for the federal funds rate. The Federal Reserve itself is neither a borrower nor a lender in this market; the fed funds rate is the interest rate that banks charge each other for overnight loans of reserves. Recall that in our fractional reserve banking system, the Fed mandates that banks keep a certain amount of reserves (either cash in the vault or deposits with the Fed itself) in order to "back up" their total outstanding deposits. At any given time, some banks have more reserves than they need, while others have less. The banks with excess reserves can thus loan them to those with deficient reserves, and the (annualized) interest rate is the fed funds rate.

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Bob Murphy [send him mail] has a Ph.D. in economics from New York University, and is the author of The Politically Incorrect Guide to Capitalism. He has a personal website at ConsultingByRPM.com

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