Rebalancing The Dismal Science

The FOMC yesterday (with Thomas Hoenig dissenting), voted to decrease the Fed funds rate 25 basis points to 4.50%. The Street got their Halloween treat, but developed some indigestion today.

One line from yesterday’s FOMC statement directly invoked Mercury retrograde’s revisit in Libra*: “The Committee judges that after this action, the upside risks to inflation roughly balance the downside risks to growth.” (Bolded emphasis mine.) Following the Fed, let’s take the Libra approach and examine both sides of the argument.

The Reasons to Lower Rates:

  • To create an incentive to invest in riskier assets. However, the Fed would have to lower rates substantially to entice investors to take on risky CDOs and MBSs. The Street is frustrated that no one will buy their toxic waste other than vulture funds at 10-20 cents on the dollar. The fact that interest rates on Treasuries keep going lower and conforming mortgages (buyers putting 20%+ down payment) are getting sold, confirms there’s an oversupply of credit for good assets.
  • More money goes into equities. Stock gains can help offset real estate and related losses. Gains (including those not taken), create the psychological “wealth effect”. (People who feel wealthier are more likely to spend money which pumps up the economy.)
  • As a preemptive measure – to help prevent the housing slump spilling over into the rest of the economy.
  • To keep the Dollar weak. This makes US exports cheaper which lowers our trade deficit. It benefits large multinational corporations when they translate their foreign earned profits back into US dollars.

The Reasons to Raise Rates:

  • To control runaway inflation. Everything people need to consume on a regular basis – food, energy, services, costs to maintain real estate (property taxes, insurance, utilities, maintenance) has increased dramatically. (The Fed and other economists say inflation is tame since all of the above are excluded from the economic data they use. One of the reasons they do this is to keep senior citizens’ annual Social Security benefit increases lower.)
  • To support the Dollar. A falling Dollar creates two problems: 1. Foreigners lose confidence and sell Treasuries en masse. 2. A falling Dollar discourages foreigners from investing in the domestic mortgage market. This will actually increase mortgage interest rates, counteracting a lower Fed funds rate!
  • To increase savings in conservative financial instruments. Higher interest rates = higher FDIC-insured CD and money market rates. The Fed’s policy of discouraging savings has put millions in financial jeopardy. Low saving rates pushed pension funds and Seniors into risky investments that have lost money. Time is not on their side to make up for these losses.

The sign of a true “Free Marketeer” (which most of the Street profusely professes to be), would recognize the party cycle is over and let the market determine fair value. Intervention only worsens the pain and prolongs a real economic recovery.

It’s human nature to like nothing but good times. Knowing change is inevitable, the smart person takes profits and not only doesn’t live beyond their means, but doesn’t live near their means so there is always a certain level of financial security. That’s what being in balance is all about.

* See my post in the Predictions section, Looking Beneath the Surface (10/4/07) for an explanation of Mercury retrograde.

Federal Reserve Related Posts in the Predictions section:
The Fed’s Trick or Treat (10/16/07)
The Fed’s Future (9/18/07)

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