Fed Set to Slash Rates: Two of Three Likely Outcomes Are Bad

The Federal Reserve is widely expected to cut rates later today; the only real question is by how much. Perhaps a better question is whether rate cuts will do any good in the short term, and what kind of long-term affect they will have on the economy.

Short term, it's important to note the effective fed funds rate -- meaning actual overnight lending rates -- has been below 1% since Oct. 10.

"The Fed is trying to lean against the decline in velocity [of money supply] -- which is essentially the same thing as a rise in the demand for money -- by expanding its balance sheet aggressively and allowing the Fed funds rate to trade well below the 1.5% target," writes Michael Darda, chief economist at MKM Partners.

In other words, today's rate cut is a formality, codifying what the Fed is already allowing (and promoting) in the open market.

Beyond such technical considerations, the Fed's goal today -- and with its recent series of rate cuts and other extraordinary actions -- is to restore confidence so that banks will lend, consumers will borrow and speculators will take risks again.

The Fed is likely to have more success with the short-term speculators, and the past 24 hours have shown the impact rate cuts (both here and abroad) can have on market psychology.

So far at least, the Fed (and Treasury) have had less success in restoring confidence. "Pushing on a string" is the term often used to describe a central bank that can't get economic activity to respond -- no matter how aggressively it acts -- because sentiment is so fragile, not to mention the banking system.

There are three likely long-term outcomes to such a scenario, and only one of them is particularly hopeful -- kinda like what coaching legend Woody Hayes said about passing the football: "Only three things can happen, and two of them are bad."

• The Fed's actions help put a floor under the economy, preventing a severe recession and paving the way for a normal recovery.
• The Fed cuts rates to zero and the economy remains moribund, i.e. the dreaded Japan scenario.
• The Fed reignites inflationary pressures by continuing to devalue the dollar via its "easy money" policies. (If you believe that's the most likely outcome, best to have some exposure to commodities, TIPs and equities since cash will become trash - perhaps literally.)