Fed Meetings Jan. 29th-30th. Are further rate cuts needed?
After being in the toilet for the past six months or so, the banking sector is starting to show a little promise again. After months of watching banks write off bad debts, investors are starting to show some hope for our financial institutions. This newfound hope and optimism can’t be attributed to the vision of bank CEO’s. Bank executives just received a temporary bailout from their new best friend Ben Bernanke at the Federal Reserve. Although it is not the job of the Fed to bail out banks from their poor decisions, it is their responsibility to ensure that the economy keeps running smoothly. When thousands of banks around the country all follow each other’s lead like a bunch of lemmings and made poor loans we suddenly have a large problem on our hands. When banks start to do bad people worry. Just the other day an older gentleman came into our credit union and asked to liquidate his entire account into cash. It came out to about $64,000. He also insisted that each bill be marked with a counterfeit pen to ensure that he was getting real currency. Obviously these actions come from someone who has lived through the depression, but if you get enough people acting irrationally like this because they feel their money is in jeopardy, then suddenly the banks will start to face some real problems.
So what exactly are the responsibilities of the Federal Reserve you may ask?
Taken straight from the Federal Reserve’s Web Site:
“Today, the Federal Reserve’s responsibilities fall into four general areas:
- conducting the nation’s monetary policy by influencing money and credit conditions in the economy in pursuit of full employment and stable prices
- supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers
- maintaining the stability of the financial system and containing systemic risk that may arise in financial markets
- providing certain financial services to the U.S. government, to the public, to financial institutions, and to foreign official institutions, including playing a major role in operating the nation’s payments systems.”
If they don’t take care of the majority of the banks, then they are not taking care of their responsibilities. So what have they done exactly to take care of the banks? On January 22nd, 2008 they came out with a surprise announcement that they would be cutting the federal funds rate by 75 basis points (1% =100 basis points) from 4.25% to 3.5%. The federal funds rate is the rate that banks make overnight loans to each other. The market for loans and savings products typically follows the movement of the federal funds rate. Since they lowered the rates, this means that mortgage rates will drop and savings products like money market accounts and CDs will drop as well.
The Federal Reserve states that “while strains in short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets.”
Let’s examine what effects this rate cut will have.
Lower rates decrease the cost of borrowing funds. A borrower can save a ton of money by borrowing at 5% instead of 7%. This means that many businesses will take advantage of the lower rates to borrow money to expand their operations. With expanded operations, they will likely need more employees to run this new operation. This satisfies the Fed’s first responsibility of “pursuing full employment.”
Mortgage rate will drop and with that comes a wave of refinancing. Many people got in on the real estate boom with loans they didn’t fully understand and weren’t fully qualified for. You can blame both parties for this problem. Lenders should have fully explained the drawbacks of the loans they were putting people into. When borrowers low introductory payments reset to higher levels, many homeowners were shocked to find that their monthly mortgage payment had almost doubled. According to an article in the Boston Globe “a record $375 billion of subprime loans reset to higher payments in 2007 and another $340 billion will reset this year.” The lower rates could be able help qualified credit borrowers refinance their loans to a lower fixed payment that they might have a higher probability of affording. Another option that troubled borrowers may have is selling their home to pay off the mortgage and either move into a cheaper home or rent. According to the National Association of Realtors, “the median price of an existing single-family home dropped 1.8 percent in 2007.” In many markets this figure is much lower, meaning that the sale of the home is not enough to cover the outstanding balance on the mortgage. This sad reality is what has led to the 75% increase in foreclosures in 2007.
Savings rates will drop. According to Bankrate.com, the national average for 1 year CDs is a measly 3.66%, down from last week’s 4.12% average. This has a very negative effect on those using CDs and other safe investment products for income. If inflation is at 3% you are hardly making any real gains in your net worth. You are just maintaining your purchasing power. When rates are low, savers tend to take their money out of CDs and money market accounts and put them into the stock market or mutual funds where they can make a better return. This could explain why the Dow Jones Industrial Average has increased from a low of 11,508.74 on January 22nd to a closing price of 12,480.30 on January 29th. That is an 8.4% return for one week. That sure beats 3.66% for an entire year!
The Fed also stated in their January 22nd announcement that “appreciable downside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks.” This statement is referring to the January 29th and 30th meetings that the Fed in having. In this meeting they will be deciding whether or not their 75 basis point rate cut was sufficient. We should be expecting an announcement sometime on the 30th. Bank stocks and the stock market in general should react inversely to the decision made by the Fed.
In conclusion, I think that the Fed will go ahead and cut rates another 25 basis points. If this cut is made it will probably be the last for a long time and should help to restore some faith and stability to the financial sector. I think a 25 basis point rate cut is necessary for the psychology and mindset of investors. It should be interesting to see how this all plays out over the coming months.