Federal Reserve & Interest Rates

Despite the efforts of the Federal Reserve in lowering interest rates to 2%, the market has not passed on theses lower rates to consumers.  In a rate cutting campaign that began last September, the Fed has tried to stimulate financial markets and ease the credit crunch that has been gripping the economy for almost a year.

Unfortunately the housing market is getting worse and that’s not helping matters at all.  With lenders still having substantial exposure to the residential mortgage market, they are being very careful about who they loan money to these days.

Consumer interest rates remain relatively high, from credit cards to mortgage rates and consumer spending is being impacted significantly as a result.  More writedowns are expected in the upcoming quarters so troubled institutions are hoarding as much capital as possible lest they meet the same fate of IndyMac Bancorp.

Back in March many financial experts thought the worst had passed but earlier this week, Fed Chairman Ben Bernanke testified before Congress stating that downside risks to economic growth have risen sharply over the past month.  It is looking less and less likely that the Fed will raise rates in September, as many were predicting in order to finally stop some of the bleeding from skyrocketing energy prices.

It’s pretty much going to boil down to when housing recovery might be possible but with government sponsored agencies, Fannie Mae and Freddie Mac going through their own financial troubles at the moment, it’s difficult seeing them stimulating the mortgage market anytime soon until they get their own house in order.

Treasury Secretary Henry Paulson has put together a rescue plan for Fannie Mae and Freddie Mac that is expected to be passed by Congress sometime next week.  He has acted quickly in making sure there isn’t a run on the company after reports surfaced last week of financial troubles for the two government sponsored agencies.

There have already been quite a few critics to Paulson’s rescue plan, some calling it a “blank” check by the government that could possibly put taxpayers on the hook for up to a trillion dollars if not more.  The two companies are involved in about 50% of the $12 trillion mortgage market so there is a ton of potential liability that the government is being exposed to.

Proponents of the plan are confident that taxpayer dollars will not be put at risk since once investors are sure of the government’s backing of the two companies.  The implicit result would be that the government would pretty much guarantee that the two companies would not be allowed to fail and would do much to bolster investor confidence in both their stock and outstanding debt.

Financial advisors have quickly moved to rate the companies’ debt as a buying opportunity as they would essentially have the backing of the U.S. government and thus having similar risks as Treasury securities yet offering higher yields.  The stock prices of two have also recovered somewhat and have led to a strong rally for financials the last two days.

This would allow the them to quickly raise large amounts of capital in a short period of time, despite the fact that based on fair value accounting rules the two companies could be categorized as insolvent.  Although they claim they aren’t having liquidity troubles currently, the housing market is steadily growing worse and that additional capital may be needed sometime soon.

Federal Reserve Chairman Ben Bernanke testified before the Senate Banking Committee in his semi-annual Monetary Policy report to Congress.  In a sharp turn around from June when he claimed downside risks to growth had diminished, the recent turmoil in financial markets has led the Fed to abandon the economic forecast it made just last month.

At present, accurately assessing and appropriately balancing the risks to the outlook for growth and inflation is a significant challenge for monetary policy makers.  The possibility of higher energy prices, tighter credit conditions, and a still-deeper contraction in housing markets all represent significant downside risks to the outlook for growth. 

At the same time, upside risks to the inflation outlook have intensified lately, as the rising prices of energy and some other commodities have led to a sharp pickup in inflation and some measures of inflation expectations have moved higher.  Given the high degree of uncertainty, monetary policy makers will need to carefully assess incoming information bearing on the outlook for both inflation and growth.

In light of the increase in upside inflation risk, we must be particularly alert to any indications, such as an erosion of longer-term inflation expectations, that the inflationary impulses from commodity prices are becoming embedded in the domestic wage- and price-setting process.

For the last couple of months speculators believed that the central bank would raise rates by September but the deepening crisis for financial markets leaves many in doubt whether they will raise rates at all this year.  That means higher energy prices will remain largely unchecked and the prediction of $180 a barrel price for oil by year’s end could be quite possible.

The housing market isn’t getting any better and many financial institutions are stuck with mortgage assets that nobody wants.  The financial sector has already raised hundreds of billions of dollars in capital to cope with writedowns from the subprime collapse but how much more can they realistically raise before investors get tired of throwing good money after bad?

Imagine how bad the economy would really look right now if it wasn’t for the economic stimulus payments that went out in May.  Consumer spending is being sustained by that right now, but that tap will be running out in another couple of months.

Basically the Fed isn’t going to worry about inflation until people’s paychecks start going up like the price of everything else is.  So while large financial institution will garner most of their attention, middle class America will remain the big loser during this economic downturn.