Monday, September 17, 2007

The Effect of a Rate Cut – Probably Zero

The excerpts below are from a WSJ article concerning a possible cut in the Fed Funds rate tomorrow. Once again a rate cut will not fix the commercial paper market, subprime mortgage market, the number of ARM resets, home builder profitability, etc. A drop in the rate will lower the value of the dollar, increase the price of gold, and increase the price of oil. If you noticed the dollar is at an all time low against the euro, gold is up at $725, and oil flirts with $80.

If the Fed thinks we should decrease the Fed Funds rate to help stimulate an economy that they think is going into recession then so be it. To drop the rate to juice the equity markets is ridiculous.

I do not see a rate cut as a positive sign.

Investors are putting a lot of hope in the Federal Reserve's ability to ride to the rescue tomorrow.

Though the stock market surged last week on optimism that a widely expected interest-rate cut by the Fed would boost stocks, such a rate cut would offer little immediate help for the fundamental problems weighing on the nation's economy and financial markets. These include a worsening housing slump and high gasoline prices, which are damping consumer spending, and fears of further defaults on the billions of dollars of low-quality loans that have been used to finance mortgages and corporate takeovers.

Even if the Fed carries out a series of rate cuts, the economy and stock market are likely to be dealing with the fallout from these problems well into next year.

Financial markets view it as almost a certainty that the Fed will cut its target for short-term interest rates tomorrow, perhaps by as much as half a percentage point, in an effort to perk up credit markets and economic growth. It would be the first cut after 17 consecutive quarter-point increases that took rates from an exceptionally low 1% in June 2004 to 5.25% in June 2006, where they have remained since.

Based partly on the market's rapid recovery after Fed rate cuts during the 1998 credit crisis, many money managers are betting stocks will surge if the Fed cuts rates now. . . . .

. . . . But some economists worry that expectations have gotten out of hand. What ailed stocks in 1998 was the combination of Asian economic woes and a Russian debt default, which contributed to the near-collapse of a huge U.S. hedge fund, Long-Term Capital Management.

The current problems are nothing like those faced in 1998, so the comparison is immaterial.

Unlike in 1998, when the real troubles were imported from abroad, today's problems are home-grown: the housing meltdown and the credit crunch that has followed.

Even if the Fed acts quickly and cuts rates more than once this year, as many economists now expect, the impact on the economy would be slow to take hold. Indeed, the housing crunch may get worse before it gets better. So, instead of taking off like a rocket, as it did when the Fed cut rates three times in the fall of 1998, the U.S. stock market may have to navigate more difficult seas.

"The bounce-back in the financial markets is probably going to be smaller than it was in 1998," when the Dow Jones industrials surged 20% from its close on Oct. 1 through the end of the year, says Jan Hatzius, chief U.S. economist at Goldman Sachs Group Inc. "We should expect further problems in the financial markets from the housing troubles."

"The recession in housing shows no sign of ending, undercutting the momentum of the economy," says Ethan Harris, chief U.S. economist at Lehman Brothers Holdings Inc. "We are likely to see consumer spending slow down." Because consumer spending accounts for more than two-thirds of U.S. economic activity, it is important to growth. . . .

. . . . In the near term, however, the big problem is that it takes months for rate cuts to translate into economic growth, by affecting things such as investment, consumer spending and exports. In credit markets, some banks have become less willing to extend credit for purposes like takeover financing, because of a fear of default. A quarter-point or half-point change in base rates isn't going to change that very quickly.

What a Fed rate cut -- or a series of cuts -- could change quickly is investor psychology.

"I think this is more about confidence, the sense that somebody has got a hand on the tiller," says Mr. Harris of Lehman Brothers. If investors believe the Fed will do all it can to get credit markets going again and keep the housing market from pulling the economy into recession, they may be willing to bet on the future by buying stocks. . . .

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