Monday, November 5, 2007

Rate Cuts Come With A Cost

Don’t ever think that there is nothing but upside to a rate cut. The last series of rate cut earlier in the decade brought us the housing bubble. Rate cuts now will probably bring us inflation. Text in bold is my emphasis. From the WSJ:

Investors have come to see Federal Reserve interest-rate cuts as the balm that cures all wounds. The truth is more complicated.

What investors seem to want and what the economy needs might be diverging. Housing-related problems have been ailing the stock market recently, particularly financial stocks. Still, it isn't clear it is ailing the economy enough to justify more rate cuts. Last week, the Commerce Department said gross domestic product rose an annualized 3.9% in the third quarter, and the Labor Department said nonfarm payrolls increased by a greater-than-expected 166,000 in October.

In the weeks ahead, housing's bad situation could put even more mortgages and mortgage securities at risk. Citigroup said yesterday it could take a hit of $8 billion to $11 billion from subprime exposure and don't be surprised if other banks and brokerages follow with more billion-dollar writeoffs of their own - a big deal for the broader stock market.

Even in a bad year like this, financial firms account for more than a quarter of the profit by companies in the Standard & Poor's 500 stock index. Financials also account for nearly a third of S&P 500 dividends. And many nonfinancial firms, like General Motors, have significant financial arms.

Of course, the GDP and jobs reports might well be high-water marks for the economy. But if the housing downturn really does start to stifle economic growth, it isn't clear more Fed rate cuts would do much to fix the problems.

The problems in housing are less related to high interest rates now than to the hangover after a period of feverish speculation spurred by low rates before. No matter how low rates go, many of the people who would have qualified for mortgages when banks were lending recklessly aren't going to qualify anymore. With home prices in many areas declining, no matter how low rates go, many people will be reluctant to buy -- using borrowed money to purchase a depreciating asset isn't an obvious step to take. What housing really needs is time to heal its wounds. The Fed can't drop that from helicopters.

To be sure, every economic slowdown brings a chorus of naysayers who say rate cuts are little more than "pushing on a string," and that always turns out to be wrong. The Fed's rate cuts after the dot-com bubble burst, for example, didn't do much to help tech firms out, but the Fed did spur other areas of the economy -- notably consumer spending and housing -- helping to make the recession strikingly mild.

But there are unintended consequences, too. When the Fed fought the tech-stock bust with lower rates, it got a housing bubble in its place. This time, with other major economies around the world feeling little pain from the U.S. housing slowdown, one consequence of more rate cuts could be further weakening in the dollar and increases in commodity prices. Both could lead to the sorts of inflationary pressures U.S. investors haven't had to worry about in a very long time.

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