Today, at 2:15 p.m., Ben Bernanke will make an announcement on interest rates. My guess is that he will cut rates by 25 basis points. Yet, with inflation above the Fed's target and economic growth quite healthy, if government statistics are to be believed, the case for a rate cut rests on predictions about the future.
Only Bernanke and his colleagues know what he'll do, but I can envision three scenarios and the market will react differently to each:
- No cut. Leaving the Fed Funds rate at 5.25% would cause investors to sell stocks -- the Dow could drop 200 or more points on such news. With inflation running above -- it was 2.36% in July -- the 1% to 2% range that comforts Bernanke, a case could be made that inflation remains a threat.
- 25 basis points cut. The market seems to expect this so I think the market would trade down modestly after the announcement because there are some people betting that the Fed will cut by even more. It's not clear what evidence the Fed could cite to defend a rate cut. The most recent GDP growth rate was 4% in the second quarter. If the Fed knows that third quarter growth will be negative, it should share those statistics.
- 50 basis points cut. If the Fed really cuts rates to 4.75%, investors will cheer and the Dow could rally between 200 and 300 points. Such a cut, however, would be seen as a bailout to Wall Street interests, and could fuel inflation, slam the already weak dollar, and cause governments and institutional investors to shift their money into bonds backed by the Euro -- thus raising interest rates.
3:30 p.m. update: Bernanke surprised me by lowering rates 50 basis points. As I thought, the Dow responded by rising over 200 points. What shocks me is that from what I've read, the cut is not based on solid evidence that inflation is under control -- oil prices are over $80 a barrel. And the drop in rates could cause oil to climb to $100 a barrel very quickly. Stagflation ho!
The interesting thing is that the problems facing the global financial markets and the economy will not be cured by cutting interest rates. The biggest problems now are at the intersection of where the finance industry overlaps with the rest of the economy, and with foreclosures at the highest rate since The Great Depression, you know that's in the housing industry.
The financial market's panic here is leading to a lack of wholesale funding for mortgage underwriters to issue new mortgages coupled with a lack of demand for mortgage-backed securities (MBS) from institutional investors. A rate cut by the Fed will not increase the supply of such wholesale funding, nor will it increase investors demand for MBSs. Furthermore, those investors -- which include hedge funds, banks and insurance companies -- are taking big losses.
This financial market malfunction overlaps with the real economy. Millions are losing their homes and they can't use their home equity to pay monthly bills. Construction companies are canning workers, home builders are fire-selling excess inventory, lumber and other supply industries are taking a hit and so are furniture and appliance companies.
A Fed rate cut would actually help homeowners with adjustable rate mortgages. However, the other industries would continue to suffer for the simple reason that there is so much excess housing inventory being dumped on the market that prices will need to fall much further before demand revives enough to put the wind in the sales of home builders and suppliers.
I think it's a mistake to look for the government to step in and solve the problem. If the market performs its clearing function without government intervention, then people who could not afford their homes will lose whatever equity they put in and can try renting or buying a more affordable house.
The issuers of dodgy mortgages can close up shop and seek employment elsewhere. And the institutional investors who make hundreds of millions of dollars a year can pay off their limited partners and lick their wounds from their waterfront estates in Greenwich, CT.
It is unrealistic to expect the Fed funds rate to fix all these problems. But when the only tool you have is a hammer, every problem looks like a nail.
Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter.
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Reader Comments (Page 1 of 1)
9-18-2007 @ 10:03AM
Keith Shepard said...
Peter Cohan wrote:
"No cut. Leaving the Fed Funds rate at 5.25% would cause investors to sell stocks -- the Dow could drop 200 or more points on such news."
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Come on...you're just being an alarmist.
9-18-2007 @ 10:46AM
Robert said...
An alarmist? I think in this scenario, a two hundred point drop would be more akin to an optimist.
I believe no cut in the rate would lead to a more severe selloff in the neighborhood of 400-500 points.
I also think a rate cut would do almost nothing to solve the problems of the current scenario. The odds of a recession before the end of the year, IMO, are much higher than the average person thinks ... I imagine 75% likelihood.
9-18-2007 @ 11:02AM
pete beck said...
Cohan is simply wrong about the importance of a rate cut.
If a rate cut will help the market -- which is much more than "Wall Street" whatever that is -- it will also help the broader economy. As stocks go up, it is easier for businesses to raise venture money and to go public and, hence, to purchase capital goods and hire employees. Also, as stocks go up, companies need contribute less to defined benefit plans, charities have more money to spend, and individual investors have more money to spend. All of these help the economy.
Equally important, if interest rates go down a bit, it is easier for creditworthy individuals to buy houses, which will help that market.
Inflation is under control. The risk now is recession. An interest rate cut is critical for both technical reasons and to improve the general climate of faith in the economy.
9-18-2007 @ 1:48PM
MTfunds said...
Peter, Thank you for showing the scope of the problem. There is no easy fix. Everything will have to correct if it still can. The foreclosures are already out of hand and this is only the tip of the iceberg. Do you realize how many people with good credit and who can afford their mortgage are thinking of walking away because their home lost so much value they are now upside down on their mortgages. Nobody is even factoring in that group they are only focusing on the subprime group. Why would someone pay on an overpriced house when they can file chapter 7 and turn around and by a cheaper house?
9-18-2007 @ 5:50PM
ALASTAIR said...
Welcome back to the Jimmy Carter 70s. Protectionishts and inflationists, especially the Democratic presidential candidates, are rejoicing at the prospect of cheap money and cheap credit.
It is time to head for the gold hills. Sell into Bernanke's stock market rally and buy commodities, especially gold mines and bullion.