Tuesday, December 16, 2008

It's an oxymoron! No! It's a conundrum!

OK. So what is it?

The Fed is lowering its official rates to under 1%, to under 0.25%! WOW! But why do it? Isn't that one of the the things that got us into this mess- rates that were too low? Why use that as a solution? Indeed, from that standpoint, this policy is a oxymoron: its a policy that is internally inconsistent. It's a solution that is, in reality, another problem waiting to happen.

But look at the markets. People can't get these low rates. Fixed 30-Yr mortgage rates are still very high and have not been responsive to Fed rate cuts. ARMS (adjustable rate mortgages) similarly have been stuck above the 5% mark with no correlation to the dropping Fed funds rates. So how if rates are falling are we to be helped if we can't borrow at them? That is a conundrum.

Oxymoron in action
But does the Fed really want us to borrow at these rates? Everyone warns about the inflation consequences of what the Fed is doing. They say, well, if you cut rates this low and keep them there for a while, when it's time to hike rates you will have a lot of liquidity to pull back. So if people do manage to borrow at these low rates aren't they taking just the risk that put us in trouble in the last cycle- at least if they borrow at low variable rates? The Fed does not want us to do that. That is the oxymoron.

So who are the low rates really for? Is this just another way to increase bank profitability?

Does it solve THE BIG PROBLEM? No...
Notice that one of the bigger issues right now is how to stabilize housing and halt the deterioration in mortgage values. One way to achieve that end is lower mortgage rates. Every 50bp reduction in mortgage rates increases house prices by about 6%. Well, not literally but what it does is if you assume that people put one-third of their income into house payments each month, a 50bp drop in mortgage rates would allow the borrower to buy a house that is about 6% more expensive. So cutting rates does help to make higher house prices affordable. House prices have fallen by about 20% from their peak; some say they have another 10% to fall. One way to blunt that would be through a 1% point cut in mortgage rates. But the Fed's rate cuts don't do that. They seem to have no impact on mortgage rates.

This is another action that does not seem to get at what ails us- the housing market. Maybe it will work, but with a delay. So far we have no hint that it will.

The Fed rate cut policy is the oxymoron that tastes like a conundrum. Let's hope that the other aspects of the Fed's approach work better than the rate cut.


Anonymous said...

Fed is doing a terrible job spear headed by Ben.
The house prices have to collapse first, and they have not yet, before anyone will buy them or rfinance them. The economy is going back to 70's or earlier because of no new job creating developments are taking palce, like PCs, internet or cell phones

kunnamkulam nostalgia said...

Thanks for the interesting blog. But could someone answer me:

1)Why the world shoul be so obsessed and affected with what 300 mn Americans have done or not done?
2)What is the real loss in asset values worldwide?
3)At the cost of some free market freedom, can not regulators look at topping out of maximum values that any equities/ finacial products can fetch in the marketplace based on certain fundamental ratios - limit the reward - limit the risk- atleast the present generation cannot squander away the opportunities of future generation and leave them in utter penury.
4) I think this is the best time people would listen to the bad words like responsibility , discipline and austerity.


Another great post.