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THE FED DID IT...
The Federal Reserve
did it – it cut rates. In lowering the federal funds rate by 25 basis
points to 4.25% from 4.50%, the Fed turned away from the signals it sent
out after the October 31st meeting. As the Fed convened there was a
sense that taking “no action” might cause too much of a shock to the
financial markets. Speculation about a reduction in the discount rate
of 25 basis points to as much as 75 basis points was rampant prior to
the meeting. Narrowing the difference between fed funds and discount
rates might encourage more banks to borrow from the Fed and help relieve
some of the stress in the money markets. A change in rates was becoming
increasingly problematic in the face of some recent economic data which
was “weak” but not “terrible.”
Since the Fed
Chairman’s speech in late November, when he raised the possibility of
another rate reduction at the December meeting, certain economic
statistics have been looking better – perhaps raising questions about
how this data might influence the Fed. This included pressure from the
White House to contain the sub-prime adjustable rate mortgage crisis, a
nominal rise in non-farm payrolls, the stable Dow Jones Industrial
Average holding just under 14,000 and slightly positive home sales
figures for October and September (revised). A trade group of
realtors insisted that the U.S. housing market is stabilizing based on
October home sales, which inched upward 0.6%. Despite the somewhat rosy
outlook by the realtors, annual home sales are likely to be down 18.4%
for 2007 over 2006.
The market had
factored in an interest rate cut. Had the Fed not done so the
consequences would have been crushing. The earlier interest rate
reductions in September (25 basis points) and October (25 basis points)
have yet to broadly register across the economic spectrum and Bernanke
is faced with the challenge of balancing the economic statistical data
with consumer psychology (which polls tell us is decidedly negative).
Thus, Bernanke will remain under pressure to open the monetary spigots
wider to pump up the economy, perhaps well into 2008 until confidence in
the economy can be restored. Market psychology has worsened in a way
they couldn't have anticipated. And the mood has worsened to a point
about concerns that it will spill over into the macro-economy. Anecdotal
evidence of the effects of the recent rate reductions should be
reflected in the Fed’s next Beige Book installment, due out in January.
The central bank needs
to signal that it's open to cutting interest rates further. Comments to
the contrary could damage market confidence. The self-interested
confidence expressed by some realtors is probably due to hope that the
recent downward spiral in home prices will further spur a nascent
buyer’s market. This will probably only happen though if lenders take
their cue from the Fed and temper their loan practices with a dose of
good old-fashioned self-interested banking practices -- i.e. weeding out
the unqualified borrowers from the clearly qualified and a willingness
to grant mortgages to the latter on reasonable terms. While the focus of
rates has been on sub-prime loans, prime home loan borrowers with
adjustable mortgages may not be defaulting but clearly have less
discretionary income. Finally, lower interest rates and the vibrancy of
the housing market will have a trickle-up effect and until both
sub-prime and prime borrowers feel an increased sense of financial
comfort, it will be difficult to give the economy a sound bill of health
and take the pressure off the Fed.
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