TO many observers, it appears a foregone conclusion that when the US Federal Reserve meets on Sept 18, it will cut short-term interest rates, possibly by as much as 50 basis points. Some have even called for a 100 basis point cut. It is hoped the subsequent easing of pressure in credit markets will spill over into equities.
While this happy scenario is plausible, it would be wise for investors not to expect too much. While it is likely that the Fed will indeed cut rates, it might not do so as aggressively as many market players predict or hope.
First, too-high rates are not the cause of the problem: much of the blame for the sub-prime mess can be apportioned to outright fraud by the real estate and finance industries and poor risk assessment. Cutting rates will be of limited use in resolving the problem.
Second, at Monday’s G-10 meeting of central bankers, one message was stressed above all others – that although central banks have an interest in securing market stability, it would be a huge mistake to bail out bad investors. Third, Fed chief Ben Bernanke, who was present at that meeting, is well aware that one of the culprits behind the sub-prime crisis was his very own organisation.
In December 2000 following Nasdaq’s crash, the Fed, then under previous chairman Alan Greenspan, began an unprecedented year-long series of rate cuts, reducing the federal funds rate from over 6 per cent to just 1.75 per cent – a level last seen in the 1950s. By mid-2003, two further cuts had reduced the rate to just one per cent. History has shown that when rates fall this low, what typically ensues is a real estate boom or worse, a real estate bubble. This is exactly what occurred in the US, where lax banking and credit industry practices helped fuel speculative demand for housing between 2003-2006, thus sowing the seeds for the present sub-prime crisis.
However, when inflation became a problem and the Fed was forced to raise rates to cope, the resulting pressure on mortgages then triggered the present collapse. Mr Bernanke, well aware of recent economic history, may be keen to impose his own personal stamp on US monetary policy and hold off on a rate cut for the time being.
In fact, there is actually very little reason to bail out Wall Street. Despite all the doom-laden headlines of the past seven weeks, the Dow Jones Industrial Average is still 5 per cent up for the year while Nasdaq’s gain is 6 per cent. From its all-time high, the Dow has only lost 6 per cent, hardly a catastrophic fall that cries out for Fed intervention.
The main reasons markets believe rates will be lowered are last Friday’s weak jobs report and comments earlier this month by Mr Bernanke that the Fed is ready to take action to provide liquidity and promote the orderly functioning of markets.
While the balance of the evidence suggests the Fed will indeed lower rates, it will probably do so in cautious calibrated fashion. Expectations of a hefty rate cut are likely to be misplaced.
Source: Business Times 12 Sept 07
