A Rate Cut Too Far

Fortunately for us, the Fed is still independent enough to rise above the noise and chatter of the market pundits. In the last two months, the Fed has cut the target Fed Fund rate 75 basis points. The effect of these cuts has yet to be felt, and won't be until at least the end of the first quarter. Fed members have been out speaking publicly over the past week, preparing the market for a meeting that will not produce a rate cut. The equity market, and increasingly the money markets are becoming addicted to rate cuts. The wild market swings this past week prove it. However, the Fed must hold the line here and wait to see what happens.

There are several reasons for this; one I have already mentioned (effects yet to be felt). Second, the Fed doesn't want to use up all of its ammo now. It needs to save some to use later if necessary. Third, the Fed doesn't want to be int the same situation a few years from now as it is in now. A strong case can be made for the idea the current situation in the markets were at least exacerbated by Fed policy on rates earlier in this decade, when rates were left too low for too long. Fourth, and most important for the Fed as it is part of their mandate, is the level of inflation. If we are truly in a global economy, some of the global inflation is going to be imported to this country. Here again, there is a lot of market noise, particularly on the commodity front. You can't open your eyes or ears without seeing the price of gold or "black gold", which given the speculative pressures in the oil market, seems to be the inflation hedge of choice these days. However, price stability is the Fed's job and they know that continual rate cuts will eventually become problematic on the inflation front.

There are two problems in the market/economy today. One is housing. The housing market was in a bubble and is now being deflated. Too many houses and too much speculation needs to be worked out of the market. As much as everyone would not like to see people kicked out of their homes, many homeowners bought properties they couldn't afford. The media and politicians have focused on the cases of fraud that occurred in the mortgage market. The reality is that this is a small percentage of cases. A large percentage of defaults and foreclosures are in investment properties, which need to be viewed like any other investment that has declined in value. The rest were properties that were bought at the height of the market, sometimes using mortgage instruments that the buyers did not fully understand (sometimes they did). The housing situation is such that it would be in the best interest of all parties to try to restructure the mortgages to more realistic levels. Banks do not want to want to foreclose on a bunch of properties they can't easily sell and don't want to expose themselves to the public relations nightmare of kicking millions of people out of there homes. Homeowners don't want to have a mortgage default on their credit history. Both sides need to take their lumps and move on.

The other problem is the bubble being deflated in the credit markets; I have already written at length on this topic. The Fed can help here and have already tried. However, they need to specifically target the liquidity situation directly. Cut the discount rate, remove the stigma of doing so, and stop making it a penalty rate for now ( the Bank of England actually calls its rate at its emergency lending facility a "penalty rate"). This will free up liquidity in the front end of the fixed income market and will allow banks to lend more freely to the "real" economy. The Fed could also look at reserve requirements, but given the turmoil and uncertainty in the banking sector currently, I'm not sure this would help at this time (I'll leave that to the Fed to decide).