By Michael Pento 

The Fed meets today to decide on whether to lower the Fed funds and Discount rate—the rate banks charge each other for overnight loans and the rate they can borrow directly from the Fed respectively. It is widely accepted that they will lower the funds target rate at least 25bps. The view that they will lower the rates is little in doubt. I however, believe they should remain static and let me explain why.

Banks operate on a fractional reserve system. Basically this means that banks are required to maintain a certain level of reserves of the money they loan out (currently 10% on demand deposits) at the Central Bank. When banks fall below the reserve requirements they must borrow from each other to comply with the regulation. The Fed sets the target borrowing rate but the actual rate called the effective fund rate is set by the market. Occasionally this rate will differ greatly from the target rate as it did in August at the beginning of this credit crisis. During the first days of the crisis the effective funds rate rose to 6%, well above the current 5.25% target rate. The reason for the rate increase was banks began to hoard cash as a result of an unwillingness to buy asset backed commercial paper which has been adulterated with sub-prime loans.

Here is where the debate begins. It is my contention that the above example of rising rates is the result of the market seeking to correct itself from a credit bubble engendered from a superfluous amount of liquidity and risk appetites in the mortgage and corporate bond market. If the market was allowed to function without interference, over time the consumer would increase his or her savings rate by deferring consumption, the banks would eventually become flush with cash and the Fed Funds rate would drop. However, given the Central Bank’s unchartered mission to repeal the business cycle we now have many from Wall Street supplicating for a rate cut.

When the Fed cuts rates they print new money—supplanting the need for savings—sending the overnight rate lower. Since the increased supply of money does not come from productivity and savings, there is no increase in goods and services to absorb the new money created. And there in lies the problem: the result of increased money supply without increases in productivity is higher prices. Inflation.

It appears the Bernanke put may be in full force just as it was under his predecessor. I agree with the consensus that the Fed will lower both the Fed Funds and Discount rate by a minimum of 25bps. Their statement may indicate that future rate reductions are subject to subsequent releases and that they will be data dependent. But their bias will be towards easing. For me, this is an abdication of the Fed’s mandate for a stable currency. Little attention will be paid to the inflationary environment that will ensue, giving way to the desire to overt even a temporal contraction in G.D.P. But the question must be asked: does a lower Fed funds rate translate to a growing economy and will it work this time around?

The degree at which money printing engenders economic growth varies greatly depending on tax rates, interest rates and future expectations for inflation. The higher the levels of taxes, interest rates and inflation the lower the output of growth and the less effective will be the Fed. The important point to remember is that no matter what the status of the economy, money printing always produces inflation. The health of our economy is highly dependent on a fully functioning money market and mortgage lending market. Given the fact that an asset that is recovering from a bubble is the last to respond to an easing monetary policy, I would expect drastic cuts to the Fed funds and Discount rate will be needed in order to bring the commercial paper market and the mortgage market into reconciliation.

The Fed, along with some economists, would like American consumers to believe that printing money has the same effect on the economy as one that enjoys a high level of savings. It does not. Record high oil prices and soaring gold seem to bear out the point that we are headed into an even more inflationary environment. If I am correct in the view that the Fed will embark on another round of aggressive money printing to bolster a flagging economy, the result will be the same as all other attempts at bailing out the consumer. The need to hedge against the devaluation of the U.S. dollar against hard assets is imperative.