Why the Fed Will Lower Rates Again on Wednesday

The Fed will lower rates again on Wednesday primarily because the financial institutions have reported much worse than expected results. The S&P500 (SPY) earnings are on track to fall 20.5% from the same quarter last year with about 160 companies having reported as of this statistic (ref. DJ story), including most of the major financial institutions. The expected fall of the S&P500 had been 9.8%, so this result is considerable worse than expected. According to Thomson Financial, excluding the results of the financial institutions, S&P500 corporate profits are set to rise 11.3% this quarter (the year end 2007 quarter). This is quite a difference from the overall fall of 20.5%.

Right now most of the larger U.S. companies are looking healthy, IBM (IBM) and Microsoft (MSFT) are two good examples. However, this may change. The losses of the financial institutions this past quarter might be the tip of the iceberg, if the Fed and the national government do not act quickly. The loan losses the banks experienced this past quarter could balloon this quarter (Q1 2008). Hence banks are allocating more money for future credit card and loan losses. Banks are restricting their lending further. People and businesses will of necessity stop spending. This will have a negative effect on all businesses. The only way to avoid this is to stop the bleeding at the banks. The Fed knows this. The national government should know this. Further the subprime problem is spreading overseas, so Bush and the Fed are getting pressured by foreign governments as well.

The Fed has to immediately and drastically lower rates to help the banks avoid the even bigger losses that will likely otherwise occur this quarter. The Congress needs to act immediately to raise the conforming loan limit. This will improve the ability of distressed homeowners to sell their homes (or to refinance them under more reasonable terms).

If these things do not happen, a huge constriction in the credit/money available from banks may send the economy into a deep recession. Strangely the recession itself may still be completely avoidable. The Fed may moan that the banks have been irresponsible, but finger pointing as always will not be a productive action. The Fed, much as it might like to do so, does not have the option of simply blaming the banks (or the real estate agents). It has to take the action that will do the most overall good. Clearly that action has to be to bail the banks out. If the financial system fails, the businesses which depend on that financial system will soon fail too. The Fed has no choice. It cannot wait for more data. It must take drastic action now to help the banks avoid huge losses this quarter. Then 3 months from now it can assess whether or not it should reverse the policy it followed this quarter. It would be foolish to wait for more data. It would be foolish to worry too much about inflation for the immediate term. Ben Bernanke knows he has to act. It is no longer a question of kowtowing to Jim Cramer. It is a question of avoiding severe problems which will certainly result without quick action form the Fed. Already one month of this quarter is gone. From the losses reported for Q4 2007, does a 0.75 basis point cut seem enough to reverse or arrest the current loan loss scenario that is playing out? It doesn’t to me. I don’t believe it does to Ben Bernanke either. Unlike lawmakers the Fed governors can easily reverse their decisions when the data begin to indicate that they should. For now they must act on the best information they have. They must cut again.