How The Fed Can Avoid Cutting Interest Rates

Should the Fed cut interest rates? A lot of the market thinks it should, and even more of the market thinks it will. But there are adverse consequences to such an action, especially on the inflation front: if the dollar weakens further on a rate cut, then prices could start rising faster than the Fed is comfortable with. And keeping inflation in check is much more important, for a central bank, than rescuing bond investors.

On the other hand, helping out the credit markets is a good idea, and important. And it just so happens that there's a good way for the Fed to do that which doesn't involve an outright Fed funds rate cut. Here's William Polley (my emphasis added):

Today's intervention was just a ripple in an ocean, but in the event that something more is on the horizon, the Fed needs to remind banks that the discount window is always there to meet their emergency liquidity needs. If anything, the Fed might consider lowering the discount rate to marginally encourage borrowing from that source rather than putting strain on the fed funds market. Lowering the fed funds rate should not be the first reaction to this situation despite the fact that many people will call for it. Lower the fed funds target only if it looks like this is not going to be contained by the financial markets.

I like the idea of the Fed cutting its discount rate – which is currently at 6.25% – rather than the Fed funds rate. That would improve liquidity in the markets, without having an adverse effect on the dollar. What the markets need right now is abundant money, rather than cheap money. All this talk of "liquidity" only serves to blur the distinction, since the word can have either meaning, or both. But the Fed can definitely provide the former without resorting to the latter.