Wednesday, September 12, 2007

10 Reasons against Federal Reserve Rate Cut

Previous: Federal Reserve Pushing on a String

Cutting interest rates to bailout markets will have 1 of 2 possible results: bad or horrible. Either the Federal Reserve will fail to prop up inflated asset prices but throw a wrench into the works while trying, or the Fed will succeed for a time and cause years of more bad decisions based on faulty pricing.

  1. Rate cuts to increase the credit supply are misguided when the current economic condition is a healthy credit-demand crunch.
  2. Rate cuts, and the Fed’s acceptance of mortgage securities as collateral alongside Treasury debt, perpetuate the information crunch about what a good investment is, not solve it.
  3. Rate cuts to increase credit/debt worsen rather than help the savings crunch.
  4. Rate cuts caused the inflated prices and bad debt problems, and more rate cuts prevent the market solution (temporary credit-demand crunch during re-pricing) from working.
  5. Rate cuts are not good for the economy as a whole, they are “good” for imperiously picking winners and losers by changing the rules in the middle of the game, so slick traders caught with the hot potato can unload junk on the next greater fool (maybe you). The Fed also burned smart investors who "shorted" the market (bet on a downturn) when the Fed changed the rules overnight with liquidity bailouts that favored one interest group at the expense of others.
  6. Rate cuts now are a panicky, profligate overreaction when the housing bubble bust has scarcely begun and at least a year (up to 5 years) of foreclosure-causing adjustable-rate mortgage (ARM) resets of interest rates remain on the horizon.
  7. Rate cuts are too late to stop the ongoing foreclosure meltdown and will do little or nothing to help the cherry-picked "poster-children" dragged in front of the TV cameras to justify a bailout--but the cuts will benefit people that you might not want to help. First, a Fed rate cut might subsidize healthy, wealthy prime borrowers who do not need help yet fail to save subprime borrowers during resets with increasing risk premiums (the rate gap between good and bad borrowers). Second, troubled borrowers are more likely to have ARMs, and most ARMs are based not on Fed funds but on the London Inter-Bank Offered Rate (LIBOR), and LIBOR has been diverging up and away from the effective Fed-funds rate, so Fed cuts are quite useless against all the adjustable LIBOR-indexed mortgages. Third, prime fixed mortgage rates are related to 10-year Treasury notes which are set by market trades, not the Fed, and are based on market expectations of long-term inflation rates, not short-term Fed-fund rates, and today's markets might be less likely to believe Greenspan's Goldilocks fairytale of non-inflationary cuts, so an inflationary rate cut might cause the standard 30-year fixed-rate mortgage rate to increase, not decrease. Fourth, Fed-fund rate cuts might have little direct downward effect on mortgage rates in today's conditions (mostly only on prime, non-LIBOR ARMs) but rate cuts will bailout the biggest fans of lower short-term US interest rates, Wall Street and financial-sector stocks.
  8. Rate cuts might be ineffective or dangerously extreme: If a 1% Fed funds rate was "needed" in the blissfully ignorant days of the bubble's birth with no excess housing supply and low unemployment, how low a rate is needed now that the much demanded tighter lending standards have obliterated swaths of buyers, remaining potential buyers (solvent investors, including dollar-rich foreigners) are gun-shy of junk assets, and there is a housing glut?
  9. Rate cuts now might cause a "liquidity trap" by plunging interest rates to near 0% interest to avoid the bubble correction and thereby leaving no room to stimulate the overall economy when the recession arrives.
  10. Rate cuts might cause a further plunge in the dollar’s exchange rate. The Bank of England and (despite continuing liquidity infusions) the European Central Bank (ECB) each announced an upward policy bias with an eye toward raising interest rates, which in itself can act like a relative Fed cut to weaken the dollar (investors expect European returns to be higher relative to US returns, so they need fewer dollars but need more Pounds or Euros to buy European investments). The Fed would have to raise rates to match the European increases simply to maintain the existing rate spread to keep the dollar competitive. A Fed rate-hold while Europe increases is like a relative Fed cut. A Fed rate cut while Europe raises rates could double the run on the dollar.

*Swiss RAISE Interest Rates 25 Basis Points, Mr. Bernanke
*Federal Reserve Bailouts Create Crisis after Crisis, Government "Fixes" Keep Driving Americans into More Debt
*Bernanke's Zimbabwe Plan for the US Economy

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