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The historical reason to lower overnight lending rates is to stimulate an economy, relieve the consumer of worrisome debt levels, and to reverse a slow-down in GDP growth forecasts. Since the Fed has a dual mandate (full employment and price stability), it is hard to understand what the recent cuts have achieved. Labor markets are looking weak, consumer confidence is lower, mortgages are higher, GDP growth outlooks have been reduced, and the trade imbalance has not been touched in reality by a weaker dollar.

If cutting rates did not create a stimulus to the economy, but rather all it did was to allow global commodities to rip higher off a deflating economy, what will a rate hike achieve? More importantly, whom will a rate hike benefit? Rate hikes are spoken of for two reasons; to reduce inflationary pressures, and to contain growth.

Inflation has been rampant for years and has stripped the value of the dollar to shreds in real terms; as such, the question that Anthony Tillman, Trade Director at The-LFB-Forex, asks, may be more pertinent; "Why did the Fed wait for so long before actually cutting interest rates? Instead of a savage 325 basis point cut that included emergency action over closed door weekends, why did the Fed not follow their previous policy of instigating sooner runs of 25 basis point moves each month?” Tillman added: “A set of smaller, earlier, controlled cuts, would have created an environment where the interbank may have actually trusted the fact that things were stable enough to lend, and therefore the balance sheets deficits may have been able to have been traded towards some kind of respectable loss, instead of being frozen. In that case the cuts may have actually found their way towards the consumer as well, if the consumer actually was the intended target that is. We would still have achieved the same goal of 2.00% rates eventually, but may have done it without seeing commodities, and therefore inflation, explode.”

The natural consequence of the credit crisis has been to see losses and greed lead to closures and redundancies, as many believe that they should have. But what was a level playing field that credit markets had created via the Treasury not pushing and enforcing regulatory standards, suddenly became a field that had bumps and potholes to play on, and any amount of “Cheap Money via rate cuts” then needed to be used to fill the holes, and not, therefore, put to work. Maybe there is no blame to apportion; maybe the markets are paying the price of feeding too long at an overflowing trough of easy credit. And maybe, just maybe, with new regulatory standards in place, the same mistakes will not happen again.

The Fed’s reasons for not cutting in smaller increments and for not starting the rate cuts sooner? (Honestly, these are the reasons given through 2007):

  • We have inflationary pressures in commodities (Oil was at $80 then, it went to $145).
  • We have wage inflation pressures (The weekly jobless average has gone from 320k to 450k, and incomes have declined).
  • We have strong GDP growth through 2008/9 (Huh? Where was that figure coming from?).
  • We have a stable overall environment (Well up until that sunny day in July 2007 when the S&P rating agency announced that LDO and CDO debt was toxic. THAT would have been the time to get the ball rolling on rate cuts, and many were publicly amazed that it did not happen).

It is no wonder that bond traders are looking for rate cuts and balance sheet renewals, but it is also a wonder how the Fed will justify raising rates with little GDP growth, and 11.5 months of unsold homes sitting on the market. The U.S. consumer is not consuming at 2.00% rates; the credit lines are frozen. They definitely will not get access to credit with higher overnight rates. The U.S. requires copious amounts of debt to be flowing around the markets and the economy, and right now that is just not happening.

Maybe it is as good a time as any to just leave things alone, and let the market sort itself out. There will be pain, there will be bank failures, there will be fear, but if this is not sorted out and changes made, the next boom and bust cycle will be with us before Mr Bernanke can say “Jack Robinson”.

Source: Let the Market Sort Itself Out