Federal Reserve & Interest Rates

Our Congress leaders and President Bush have agreed to go forward with the fiscal stimulus package. The plan is to distribute $150 billion into the hands of U.S. consumers with the hope that the extra cash flow will encourage spending. With consumer spending at a low point comparable to previous years, Bush and Congress members hope the incentive will spur the retail market. For this economic stimulus plan to work, consumers need to start spending.

The stimulus will be distributed depending on marital status and dependents. Single people would get $600, Married couples would get $1,200, and those with children would receive $300 per child in addition to the initial funding.

In order to effectively boost the economy a majority of the people receiving the stimulus package have to feed it back into the economy. The president and Congress are hoping we will take a vacation, buy a computer, or get some new clothes. Some people are prone to spend any extra money they have, but with the economy slipping the way it is, consumers are more hesitant to let go of their cash. This is in fact why consumer spending over the holiday season was much less than expected.

Many people will probably be looking to pay down debt or hold on to the money. Savings accounts and CDs are definitely places where some of this money is headed.

Will the new stimulus package work to boost the economy? Some people will at least spend a little bit more then they would if they didn’t have the extra cash from the government. That should help a little bit. Consumer spending accounts for more than half of the nation’s economic performance. If a good amount of people spend the money, it could give a short term lift to economic conditions.

What about the long term? Who knows?

The stimulus plan has yet to pass the House floor next week before a final decision is made. The move doesn’t seem like it would be enough to stave off a recession, but it could help consumer spending even the money isn’t spent right away.

Alan Gayle, senior investment strategist in Virginia thinks that this move, in conjunction with the recent surprise rate cuts, is a positive move for the economy. He thinks the market could definitely benefit from these moves, but it will take time to really see the effects.

European Central Bank president, Jean-Claude Trichet made it clear that inflation is a top concern. He was firm in stating that rather than cut rates, the best move is to concentrate on keeping inflation low, unlike the U.S. Federal Reserve which cut rates sizably on Tuesday. European investors’ hopes of a rate cut by the ECB have, for now, been diminished. Trichet believes that taming inflation will help soothe the markets as well.

One major difference in the role of the European Central Bank in contrast the our Federal Reserve is that their responsibility is to keep tight reigns on inflation. The United States Fed has the legal responsibility to promote employment as well as balance inflation.

Yesterday in his Keynote Address to the European Parliament, ECB president Trichet stated:

I trust that in all circumstances, but even more particularly in demanding times of significant market correction and turbulences, it is the responsibility of the Central Bank to solidly anchor inflation expectations to avoid additional volatility in already highly volatile markets. Also important is for the Central Bank to ensure an orderly functioning of the money markets at the level of interest rates required for anchoring the inflation expectations.

Jean-Claude Trichet also implied that different actions might be necessary should economic conditions change or crisis arises. He stated:

In order to ensure effective crisis management and resolution at the EU level, it is crucial that all responsible authorities maintain a high degree of preparedness to handle the complexity of a cross-border crisis situation, while preserving the necessary flexibility of action. Every crisis situation is unique and the arrangements for crisis management and resolution cannot anticipate the full range of causes, propagation channels and outcomes of financial disturbances.

Investors speculate that the European Central Bank will need to cut interest rates later this year. The U.S. economy might impose a slight downward pull to the global markets. If the European economy gets an ease in core inflation they may have the opportunity to reduce interest rates. Trichet believes that it is currently in the best interest of the economy to maintain the current rates.

The Federal Reserve cut interest rates Tuesday, January 22, 2008, just days ahead of the scheduled meeting set for the very end of the month.

The rate cut was ¾ of a point, making the current rate 3.5%.  This sizeable rate reduction is the biggest cut in a little over two decades.  The discount rate, the rate banks are charged by the Fed for borrowing, was also reduced to 4%, another 75-basis-point decrease.

According to the Fed’s statement, this action was taken “in view of a weakening of the economic outlook and increasing downside risks to growth.”  This urgent reaction was a result of reports showing continued deterioration in the broader financial markets and “a deepening of the housing contraction as well as some softening in labor markets.”

The FOMC statement also reported continued concerns about inflation and other downside risks to the nation’s economic growth.  The Fed intends to keep a close eye on inflationary pressures in the coming months.

Economists say the moves looks like a panicked decision.  Some say the Fed action is revolving around changes in the market.  In the midst of market turmoil, it seems the move was primarily a rescue. The last several rate cuts have been criticized as moves to favor investors.  The Chairman, Ben Bernanke, has defended the actions in previous months to be in favor of long-term economic growth.

Standard & Poor 500, as well as the Dow fell 1.1% today.  This was a modest decline after a weak opening.  News of the rate cut certainly encouraged investors.  On the global markets Asian stocks plummeted steadily and Brazil hot up 4%.

Analysts are split as to whether or not the Fed intends to make additional cuts at the scheduled meeting on the 29th.  It is possible that we see another rate reduction next week.  Recession continues to loom as a dark hovering cloud over the economy.