Why The Fed Shouldn’t Cut Rates

Why The Fed Shouldn’t Cut Rates


September 11th, 2007 by investoid




As I mentioned in my last post,
the US Federal Reserve is under pressure from the financial markets to
cut their funds rate by a quarter to half a percent. As a result of an
increase in sub-prime mortgage defaults, higher risk debt issues are becoming quite illiquid.
This has caused a credit crunch for some firms who rely on junk bonds
and the like to finance their operations, while various hedge funds and
purveyors of collateralized debt obligations are feeling the pinch from
low prices and no buyers.

The fear is that this housing calamity
is spreading to the rest of the US economy, thus affecting overall
growth and strength in important areas such as consumer spending and
business investment. A rate cut would not only spur on these areas, but
would re-invigorate the credit markets. With inflation within (or close to) the Fed’s target range, they can afford to cut rates. So, why not do the ‘right thing’ and keep the economy going? In fact, with the market pricing in a half percent cut, wouldn’t keeping the rate the same just be punishing investors already spooked by the recent downturn?

Not so fast. Just because a sub-sector
of the credit markets is in trouble, doesn’t mean that the whole system
requires stimulus at this point. As this Financial Times articles notes,
“this is far from the greatest credit correction of all time”. We are
far from a wide-scale crisis at this point. Furthermore, I believe that
in our financial markets one person or company’s pain is another’s
opportunity. If credit markets are seizing up, it’s because the typical
buyers aren’t willing to buy anymore. That doesn’t mean that the
securities being peddled are worthless, just that they aren’t in vogue
right now. But in these capitalistic markets there are always someone
trying to get an edge. I suspect that many hedge funds and other large
investment houses are re-pricing these phantom ‘AAA’ rated securities. In fact, there are several companies openly saying that this crunch will be good for business in the long term. Canadian banks also seem to think this is a good thing.

I’m not going to harp on about the Fed being in a moral hazard situation, but if you’re a Mad Money
fan get Cramer to answer this: does he really think even a percentage
point cut to the Fed rate will save people from losing their homes?
Just because the prime lending rate goes down doesn’t mean that high
risk rates will go down as much, or even at all. In fact, I would guess
that such rates will increase,
regardless of what the funds and prime rates do, because of the higher
perceived risk of default. And if a person who’s in an adjustable rate
mortgage whose teaser rate is about to end and his new rate will be
prime + 3% or more, do you really think that a 100 basis point cut will
really matter in terms of his monthly payment? Assuming that the person
has a $200,000 mortgage on a 25 year amortization and had a teaser rate
of 4%, they would have paid $1047 per month. Assuming their new rate is
prime + 3%, then at current rates
their monthly payment is going to be $1918, while their payment with a
percentage point cut would be $1795. Either way, if the person wasn’t
ready to pay 90% more in monthly housing costs, I doubt they’re going
to be ready for a 70% increase either.

The bottom line is that capitulating
to the financial markets desire for continuing cheap money does nothing
to wring out the excesses currently in the system. By prolonging their
existence, they are more likely to cause long term harm, as we have
seen in Japan’s sclerotic economy since their own real estate bust.
Because Japanese banks weren’t able to go out of business or even fully
disclose their bad loans, the excesses were never fully brought to
bear. Only in the early 2000’s did a special task force make Japanese
banks own up to their bad debts. Despite their 0% interest rates for
many years, their economy has continued to stagnate. I’m not suggesting
that this is the only reason for Japan’s continued growth lag, but it
is a contributing factor.

I don’t expect the Fed rate to remain
at 5.25% on Sept 18, but I think there is a strong case to be made that
it shouldn’t be reduced. If the board of governors decides to only cut
by 0.25%, expect to find many bargains around the world that day.