Thursday, September 13, 2007

Will a Rate Cut Next Week Do Any Good?

The question that needs to be asked of the business community is whether or not a rate cut next week will do any good. This question also needs to be asked in reference to the following truism: the Fed cannot stop a recession if it is going to happen. Therefore, it is time to think through the value of a rate cut. A rate cut next week is not going to help out those with big mortgage resets, it will not help those that need to re-finance their homes except for a marginal few, it is not going to restore liquidity to the capital markets, especially the commercial paper markets, it may not improve consumer spending is unemployment continues to rise, etc. A rate cut will decrease the value of the dollar and signal to the US and the world economies that the US may be sliding into a recession. Just some thoughts before reading the following from
Problems in housing, the financial markets and the first job decline in four years have made a Federal Reserve rate cut next week all but certain. But it has also raised talk about a recession -- and whether the Fed is able to prevent one.

While most economists still don't believe the nation will fall into a recession, there is general agreement that the economy now faces a greater risk than there was only a month or two ago.

But many economists also say that the Fed can do little at this point to address many of the factors threatening continued economic growth. Some economists even argue that rate cuts could make matters worse.

The mortgage market would seem to be where the Fed could have the most effect. Most directly, a rate cut will reduce the rates for adjustable rate mortgages, one of the types of loans that has caused the problems for lenders and subprime borrowers, those with less-than-perfect credit.

An estimated 2 million homeowners face sharply higher mortgage payments when their current loans reset over the next year. So a Fed rate cut could possibly stave off a wave of foreclosures.
But others say a rate cut won't solve the problem for those who have been paying low teaser rates on their mortgages with the expectations that they would be able to refinance before rates reset.

The fact that investors no longer are willing to buy securities backed by such non-traditional mortgages could make it impossible for hundred of thousands of those homeowners to refinance.

"A rate cut even down to zero percent doesn't make those attractive investments," said Edward Leamer, director of the UCLA Anderson Forecast, which now puts the chance of recession at about 30 to 35 percent. "The Fed is in the situation where they should not be thinking about saving housing, they should be thinking about isolating the problem strictly to the housing sector."

The mortgage problems have clearly led to a broader credit crunch in financial markets, which has already put a crimp on the financing of some proposed mergers.

While a Fed rate cut may help get those markets functioning more fluidly once again, there is debate among economists about how great a risk the credit crunch poses to the overall economy.

"It's pretty hard to draw strong lines between the credit crunch on Wall Street and the economy, except in real estate," said David Kelly, economic advisor for Putnam Investments. "If there are some deals delayed, it's not a problem for real economic activity. In fact, usually mergers and acquisitions cost jobs. They don't create jobs, except with Wall Street firms. Outside New York, there shouldn't be much impact."

But Putnam's Kelly said that if the Fed signals that next week's cut is the first of a series of many, it could put some needed spending by businesses and consumers on hold, as they wait to see how low the rates will fall, and how much the economy is going to slowdown.

"The Fed could contribute to the problem while fixing it if they're not careful," said Kelly. "If the Fed promises further cuts, it gives people reasons to have doubts about the economy and a reason to wait to make investment decisions. If you're trying to pick up a house at a bargain will you do it now or wait 6 months? You'll wait six months."

Another risk to the economy would be a drop in foreign investment here, according to some economists. And a Fed rate cut might cause more problems than it fixes because lower rates would make some U.S. investments, such as government-issued Treasurys, less attractive to foreigners.

"Last year we had $1 trillion came in net foreign investment, most of it into the bond market, and most into private bonds, not Treasurys," said Wyss. "If that money stops coming in, that's going to be a big increase in borrowing costs."

A sharp drop in foreign investment would also feed into the slide in the value of the dollar, which hit a record low against the euro on Thursday. While that would make U.S. exports more competitive, it also would likely raise the price of imported goods and hurt the spending power of U.S. consumers, who have come to count on low-price imports for everything from food to clothes to cars.

The Fed also has little ability to affect another risk to the economy: high oil prices. Crude oil prices hit $80 a barrel for the first time Wednesday.

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