Do Rate Cuts Really Make an Impact?

I find it very interesting that Wall Street has soared the last two days on hopes of more Fed rate cuts. On one hand, this makes sense, but on another, it baffles me.

First of all, stocks do better historically when rates are falling. It's a mathematical relationship; lower interest rates increase the present value of future cash flows and vice versa. Lower rates also make stocks more attractive relative to other income-related asset classes. That's the general concept propelling stocks higher this week, but what about the specific situation we face today?

The current dislocation in the credit markets has really hurt the market lately. We all know the state of the housing, mortgage, and mortgage-backed securities markets, but a general lack of liquidity in many other areas of credit are really having a negative impact on the ability of many companies to conduct normal business lines that require liquidity to fund operations.Will more Fed rate cuts help this part of the problem? The market's move in the last two days signals that it will, but I am skeptical.

My thought process isn't very complex. The liquidity crisis has gotten meaningfully worse since the Fed started cutting rates (there have been 75 basis points of cuts so far). To me, that indicates that another rate cut on December 11th (even 50 more basis points) won't have as much of a positive impact on the credit markets as recent stock market action would have you believe. What do you think?

Comments

[abbottmd:]

I agree. Rate cuts are pointless. They may help prior malinvestments limp along a little further, but this is really just a socialization of losses across society via inflation.... why is everyone so willing to do that? probably because they somehow think they'll be on the beneficial end of it somehow. When we get inflation out of control , few can be on the winning end.

2007 Dec 02 10:29 AM

[abbottmd:]

I agree. Rate cuts are pointless. They may help prior malinvestments limp along a little further, but this is really just a socialization of losses across society via inflation.... why is everyone so willing to do that? probably because they somehow think they'll be on the beneficial end of it somehow. When we get inflation out of control , few can be on the winning end.

2007 Dec 02 10:29 AM

[doubtingtom:]

I believe we are robbing Peter to pay Paul. In simple terms lower rates mean more money in the market and the more money out there the less it is worth, in other words inflation. To curb inflation you reduce the amount of money in the market usually by raising interest rates, maybe even double digit interest. I believe this is a dangerous game the Fed's are playing.

2007 Dec 02 11:11 AM

[pacel5:]

Last time the fed lower interest rates (Greenspan) the conditions were different. NOw we face high commodities prices. Wall street are the only ones benefiting here and thus there pressure on the fed. The market will eventually come down and hit the summer's low.

2007 Dec 02 11:47 AM

[pacel5:]

Last time the fed lower interest rates (Greenspan) the conditions were different. NOw we face high commodities prices. Wall street are the only ones benefiting here and thus there pressure on the fed. The market will eventually come down and hit the summer's low.

2007 Dec 02 11:50 AM

[Austrian Sc...:]

Since the more the fed reduces the overnight rate the worse the market is, how about we try raise them instead?

Reducing rates now is just prolonging the necessary correction. This will just cause a prolonged period of funk after the Fed has finnaly shot their wad. In other words "I think we're turning Japanese, I think we're turning Japanese I really think so..."

Good points abbottmd

2007 Dec 02 11:59 AM

[whidbey:]

Yes, you are correct. Rate cuts are mind candy, but that first impact is quickly gone, and the second impact comes later when the rates work their way thru financial markets - repricing the cost of capital. That takes 6 to 18 months to show up in the balance sheets of businesses. Between the two jolts there is room for much havoc. Dollar dives, oil rises, and I think the consumer will slow spending and all hell will break loose at the Fed. Maybe FFunds at 2.5% before the election. Actually, I do own some gold outside the US. Be careful it is not what it seems out there. jc

2007 Dec 02 01:51 PM

[texasgolfer:]

If rates are zero and you can not afford it, who cares?

2007 Dec 02 06:58 PM

[avcacio:]

Great point texasgolfer... Even if home rates drop to 1%, are you finally convinced to spend $400,000 for a small home that was just $150,000 back a few years ago?

2007 Dec 02 10:23 PM

[avcacio:]

Great point texasgolfer... Even if home rates drop to 1%, are you finally convinced to spend $400,000 for a small home that was just $150,000 back a few years ago?

2007 Dec 02 10:23 PM

[mstrb:]

A rate cut will probably only exacerbate the problem(s). It will definitely have a detrimental effect on the value of the dollar. While that may be helpful in increasing export business (and reduce the trade deficit), it in no way will alleviate the high cost of energy and the concomitant effect that is having on "inflation". The flowthrough of that high cost (to food and other purchases), which does not seem to be recognized by government generated indexes, is probably contributing more to the inability of everyday people to meet their mortgage payments and to the decline in consumer sentiment than the "mortgage crisis".
What impact has the 75 basis point reduction in rates had on the cost of energy? If you were an oil exporting country and the value of your production was deteriorating relative to goods you were buying in other currencies and your investments denominated in dollars was declining, would you be inclined to work to lower the price of that product? What direction has the price of oil moved since the Fed started lowering rates in September?
Some other solution, that would segregate the "mortgage crisis" from impacting liquidity in the other areas of credit, would be much more helpful than any further reduction in interest rates.
If the Fed cuts rates on the 11th, I will be seriously looking to reduce my stock exposure in the the U.S. markets. The impact of such a move by the Fed will most likely affect our stock market (and economy) negatively looking 6 months to a year down the road.

2007 Dec 03 03:19 AM

[Walter Mundell:]

Sorry, I dont agree. History tell us (and spreadsheets) that stock markets, 80% of time, increase prices when the economy is growing. And, when the economy is growing, inflation expectations increase too, as the FED Funds.
Stocks do better when FED Rates are increasing, as the yield curve too.
A quick look at some charts can tell you the facts.

2007 Dec 05 08:53 PM