The Fed is scheduled to announce the results of its latest rate-setting meeting at 2:15 this afternoon. Most analysts expect it to cut rates -- at least 25 basis points (100 basis points = 1%). I'm just not sure I understand why the Fed keeps cutting.

There are two reasons that come to mind as possibilities. First, the stock market seems to love hints that the Fed will cut interest rates. Since the summer, whenever the stock market fell a few hundred points, Ben Bernanke or another Fed governor would give a speech using key words such as "flexibility" and the stock market would rally. That's what happened a few weeks ago when the Dow dropped below 13,000 and it magically rallied 750 points.

A second reason is that the Fed thinks that a recession is in the forecast due to a freeze up in the credit markets, and that it's better off cutting rates to ease the pain. If a doctor had only one kind of medicine -- say, aspirin -- then the doctor would prescribe it to all patients, because it was better to give the patient something than nothing at all. This approach would work if the patient had a headache -- but it would be less effective if the patient had cancer.

In the case of the current economic situation, I think the Fed is prescribing aspirin for a lung cancer patient. Unfortunately the analogy fails a bit, because unlike aspirin for a lung cancer patient, cutting interest rates has some negative side effects. In particular, it causes the dollar to decline in value and contributes to rising oil prices, which fuel inflation.

Why is cutting rates ineffective for dealing with the economic problems we face? Because those problems are caused by hundreds of billions of dollars worth of toxic waste in our financial system. I am not exactly sure how big the problem is, but I do know that it is directly related to asset-backed securities (ABSs) -- bundles of mortgages, credit card receivables, auto loans, construction loans, and leveraged buyout loans -- which are worth somewhere between 25% and 45% of the value stated on the books of the banks, insurance companies, pension funds, and other institutions which own the ABSs.

To remove the toxic waste, the ABS holders need to write down the value of these assets. But they cannot afford to do so without simultaneously raising capital to offset the amount they are writing off. As I posted yesterday, the solution is for those who generate capital through profit to inject capital into institutions that created the illusion of prosperity through debt. I don't know whether there is enough such capital in the private markets to achieve this recapitalization.

However, because interest rates were so low already before the Fed began cutting rates a few months ago, it will not be able to recapitalize the banks by creating a spread between the 7.25% that banks can charge borrowers and the 4.25% the Fed charges its borrowers. The problem is that the spread between the loan and deposit rates is not wide enough to permit the kind of interest income generation needed to fill the capital gap.

So I am left with the question: Why is the Fed cutting rates? I really don't know. Do you?

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.