With the Fed rumored to be contemplating a rare 100 basis point rate cut, it's worth considering whether this policy is doing any good. I'd say those rapid rate reductions are doing more harm. Here's why: non-stop interest rate cuts make business lose confidence in the Fed – since those cuts are ineffective – while signaling that economic conditions are desperately bad or that the Fed is panicking and unable to fix the problem.
I think the problem is that banks and other owners of Collateralized Debt Obligations (CDOs) and other asset backed securities have not accounted yet for the true loss in value of these securities. Therefore corporations and others that deal with the banks don't know whether those institutions are solvent. The solution would be to write down the value of those assets and then recapitalize the banks to the extent of the write downs.
While the non-stop interest rate cuts do not solve what's ailing the credit markets, they also accelerate inflation. This causes businesses to hoard their money because they expect that it will be worth less in the future. In effect, the Fed is creating very high inflationary expectations which creates a very high hurdle rate for investments – and in a slowing economic climate, there are not many investments that can earn a high enough return to get green-lighted.
Ironically, the Fed's moves are actually raising the cost of capital because of the higher inflationary expectations and because the banks are so capital constrained that they will only lend to the highest quality borrowers and will lend to them only at very high rates.
How is this vicious cycle broken? This vicious cycle is broken by lowering inflationary expectations. This is accomplished by raising interest rates as Paul Volcker did in the early 1980s – as high as 20% -- after a decade of stagflation. This caused a nasty recession after which the stock market began an 18 year bull market.
I am not saying that we need to raise rates now. Instead, I'd advocate that the U.S. participate in recapitalizing the U.S. banks with help from U.S. private investors. In exchange for this bailout, the U.S. should require bankers to keep a portion of their pay in escrow so they'll take risk into account in the future. The U.S. should also demand more transparency in valuing bank balance sheets.
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)
3-18-2008 @ 12:49PM
Kent Vining said...
I do not know the writer of this article, but his assertions about each event that will occur are absolute and not shaded in any uncertainty. Therefore the assumption is he is an entertainer not a scientist. While I agreed with a few of his assertions, the rest of his article is pure puffery.
3-18-2008 @ 1:43PM
Sheldon L said...
My good colleague: I beg to differ,
"businesses to hoard their money because they expect that it will be worth less in the future"
Exactly the opposite is true. Inflation stimulates the spending of cash in favor of commoditites and other equities. Those holding cash in a highly inflationary environment are going to lose the most.
Historically, where hyper inflation has occurred people have even had negative checking accounts.
As someone directly involved with the deployment of capital I can assure you we will be doing so and taking advantage of the lower interest rates wherever we can. I cannot imagine hoarding something that is rapidly depreciating. One might hoard gold, but not cash. Perhaps you mispoke or I misunderstood?
3-18-2008 @ 2:18PM
bob friedman said...
this is just bs. the economy is tanking, and
the fed is trying to bail out their friends. dont think that would bail me out if i made a bad investment.
personally i have sold all of my stocks, and have put some in cds, and put the rest in play shorting the 500 index
3-19-2008 @ 5:14AM
wdmurphy said...
whoever reads this my advice is to use ur federal rebate checks to pay off ur credit card balances as quickly as possible and i would suggest paying off bank of americas cards first so that the initial public offering they made today puts them out of business and takes country wide financial with them. maybe then the credit card companies will take notice of their preditory lending practices that have been going on for years. taking down the largest company will allow the survivors to alter their way of cheating u the consumer and im sure the lobbyists who have put them in this position will not be able to stop what the average american is feelign at this time . reamember its ur families lives that r now at stake in this battle of underhanded misuse of our government people and it has to be stopped.
3-19-2008 @ 5:20PM
Derek Buckowsky said...
The Fed's rapid rate cuts do not induce the least bit of confidence; the author is exactly correct, as the Fed is sending signals to investors that there is a crisis - just look at the Sunday night rate cut, and the fact that $250B investment bank, the fifth largest in the world, was reduced to $2B in merely three months.
Unfortunately, the subprime crisis is neither "contained" as characterized in 2007 by our genius officials, nor is the housing situation in for a "soft landing" as described in 2007. Things will get worse, and lowering rates will only prolong the devastation. Jingle mail will continue to rise and over-leveraged banks holding ingenious derivatives will ultimately cause serious damage to global economies.
It's too bad Volcker is 80 years old, because he is someone this country needs.