While the Federal Reserve’s 50 basis point rate cut yesterday makes good theatre, it makes very little economic sense. But having exhausted its arsenal of other weapons, rate cuts are one of the few items the Fed has left to help restore confidence, even if the value is symbolic rather than practical.

The cut will make no difference to the availability of credit or anyone’s actual borrowing cost.

The only institutions which borrow at the very short end of the curve are banks and issuers of commercial paper.

But the Fed has already flooded the market with so much excess liquidity that interbank borrowing rates in the fed funds market have actually traded BELOW 1.00% every day since Oct 16. Cutting the target federal funds rate from 1.50% to 1.00% is a purely theoretical reduction — since the market has traded below this level for the last two weeks, and the Fed has take no action to make the target effective and binding by removing excess liquidity.

Nor will the cut will not make much difference for corporate and household borrowers since their borrowing rates are tied to the longer parts of the yield curve plus a credit spread.

The Fed’s rate-cutting campaign has had some success bringing down yields on longer-term Treasury securities, but spreads have continued to widen, negating the benefits for ordinary borrowers.

The last time the Fed cut interest rates to 1.00%, in Jun 2003, yields on 5YR Treasury notes stood at 2.50%, yields on 10YR Treasury bonds stood at 3.50% and seasoned Baa-rated corporate borrowers were paying 6.35%.

This time, yields on 5YR Treasury paper are marginally higher (2.75%) as are yields on 10YR paper (3.90%) but yields for Baa-rated issuers are more than 300 basis points higher at 9.50%.

Shaving 50 points off rates at the short end of the curve will do nothing to ease the pressure on banks, corporates and household borrowers as long as investors stay concerned about a deteriorating economic outlook, falling home values, job losses, and slowing corporate profits, all of which threaten to undermine repayment ability and cut collateral values. Default risk and the associated credit spreads, not the interbank funding rate is now the problem.

The last time the Fed cut rates to 1.00% and held them there for more than a year, amid concerns about a sluggish economy and possible defaltion, it stimulated the debt-fuelled housing boom that is the root of the current crisis. Most commentators now agree interest rates were cut too low for too long in the early 2000s – and there are signs that a growing numbers of Fed policymakers agree. So why repeat the same mistake again?

More importantly, what is the Fed hoping will happen as a result of the cut? Do policymakers really want households and corporations to respond by taking on even more debt? Most are having enough difficulty paying the loans they already have.

In the event, a new borrowing boom is unlikely. The current problem is not the price of short-term money (which is cheap owing to the multiplication of Fed liquidity facilities) but the quantity of longer-term credit (which remains scarce).

Credit requires healthy banks and healthy borrowers.

Defensive qualities of Lloyds TSB/HBOS combination are underestimated
We estimate that the potential cost synergies are likely to be GBP1.8bn p.a. by 2011e and calculate a negative goodwill of c.GBP20bn on the discounted acquisition of HBOS at a fraction of its intrinsic worth. We expect strong growth in pre-provision profits over the 2008e-2011e period and despite the prospect of rising bad debts as the recession bites, underlying PBT in 2010e should be at a similar level to 2008e, although earnings will fall in 2009e. Following the capital injection (Darling Plan), we project equity Tier 1 ratios of about 9.5% (end 2008) for both HBOS and Lloyds TSB.

The management, led by Tim Cockcroft, chief executive, already owned one-third of the business. It has now bought the remaining 67 per cent from the administrators in charge of winding up Kaupthing’s UK banking business for an undisclosed sum.
While the capital markets business was always an independent legal entity and did not go into administration with the rest of Kaupthing last month, the troubles of its controlling shareholder cast a pall over its ability to do business.