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Federal Reserve

delivered its first interest rate cut since December 2001, but the larger-than-expected half-point reduction in the federal-funds target rate stirred up numerous questions. Chief among them are how effective the rate cut will actually be and whether the Fed is running out of ammunition in its bid to help heal the nation's economy.

On Wednesday, the Fed cut rates by half a percentage point to 1.25%, a bigger reduction than Wall Street expected. Federal-funds futures prices suggested that market participants had put the odds of a quarter-point rate cut at 100% and at 16% for a half-point cut. The rate cut drops the fed-funds rate to its lowest level since 1961.

As for the unanswered questions, we should start by evaluating whether the half-point move was better than a quarter-point cut and why the Fed felt that inaction wasn't an option.

Aggressive Cut

I believe the main reason that Fed members felt they had to move was because the market's expectation for an interest rate cut had been bolstered substantially by the central bank's own words. In

three separate articles appearing almost simultaneously less than two weeks ago, the Fed appeared to signal that a rate cut was on the table.

The last thing the Fed ever wants is to contribute to volatility by leading the markets on, only to disappoint them later.

As to why the Fed chose to cut rates by 50 basis points rather than 25 basis points, there are a few possibilities. First, a key goal of the Fed has been to keep the fed-funds rate below the inflation rate. In doing so, the Fed maintains a powerful incentive to invest rather than save.

For example, if the inflation rate on real estate was higher than the return on savings deposits, this would tend to encourage investment in real estate, rather than savings. On the other hand, if the inflation rate were to fall and real estate prices were to rise at a slower rate than the savings rate, investors would be more likely to save than invest.

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By keeping the fed-funds rate below the inflation rate, the Fed encourages those who are holding the nearly $5 trillion in so-called zero maturity assets to invest rather than save. This helps to avoid a Japan-like situation wherein the savings rate has soared owing to fears of deflation.

Another reason the Fed acted aggressively was to combat the high degree of liquidity preference that exists in the economy. The Fed seems worried that the money that's been put in the financial system isn't being recycled in the usual way. As a result, a superfluous amount of liquidity is required, and I'll cover this a little later in the column.

A third rationale for the half-point cut is merely as insurance against the possibility of a double-dip recession. The Fed opted for a similar strategy at the end of 1991 when the nascent recovery of that year appeared that it might be stumbling.

Against the Greenspan Doctrine

The Fed's decision is surprising given its earlier indications that the current economic slowdown is a bump in the road. The Fed believes that the recent slowing is typical of economic recoveries, which tend to move along unevenly in their early stages. After the end of the 1990-1991 recession, the unemployment rate didn't peak until 15 months after the recession ended. In addition, the Institute for Supply Management's index (formerly the NAPM index) dipped below the critical 50 mark seven times over a two-year period after the early '90s recession ended.

Also, consider that if the cut was meant to have an impact on the market, one could easily question how long that impact will last. A few hours, days or weeks? The poor response to the Fed's 11 rate cuts in 2001 clearly suggests that cutting rates by a half-point merely to have an effect on the market could be a faulty decision. Moreover, the Fed isn't interested in altering rates for short-term effect.

Ultimately, a half-point cut risks hastening an economic rebound, thus creating conditions that in future years will lead to interest rate increases sooner than otherwise would be the case. This goes against a key doctrine of Federal Reserve Chairman Alan Greenspan, who has conducted monetary policy in a manner designed to create sustainable economic growth and avoid boom-bust scenarios.

What It Means

The 12th rate cut won't help many of the economy's ailing sectors but should be positive overall. Fed rate cuts aren't merely symbolic gestures; in an interest rate targeting regime the Fed must add money into the banking system in order to change the fed funds rate.

Additional liquidity is necessary in the current situation because it is clear that liquidity preferences are extraordinary. The Fed needs to provide for those individuals and companies that remain risk-averse and for those who continue to be risk-takers, investing in financial assets and in the real economy.

As to whether the Fed is running out of ammunition, remember that in order to bring rates even lower, money must be added to the banking system. If the fed-funds rate were to be cut to zero, the added liquidity would be massive. The Fed can also take other measures such as purchasing Treasuries if it feels additional monetary stimulus is needed.

Even if some uncertainties remain, in the final analysis, the Fed's aggressive rate cut, combined with the Republican victories in the House and Senate, could well keep encouraging investors to look beyond the valley to a period when economic activity will be stronger than it is today.