Federal Reserve & Interest Rates

As expected, the Federal Reserve didn’t make any changes to interest rates at this month’s Open Market Committee meetings.  In it’s news release, it cited weak credit markets though it is still concerned with the threat of inflation.

Economic activity expanded in the second quarter, partly reflecting growth in consumer spending and exports. However, labor markets have softened further and financial markets remain under considerable stress. Tight credit conditions, the ongoing housing contraction, and elevated energy prices are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities, and some indicators of inflation expectations have been elevated. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

Financial markets remain fragile as more writedowns are expected and mortgage markets continue to deteriorate.  It is looking increasingly likely Freddie Mac may be forced to use the government’s rescue plan sooner than expected, having reported large second quarter losses this week.

The good news is that oil prices have continued to fall this week and have shed about $30 from it’s high in mid July.  Increased output from Saudi Arabia and decreased global demand from slowing economies have finally made a dent on oil’s meteoric rise over the past year.

Only a single member of the Open Market Committee, Richard W. Fisher, voted to raise the Federal Funds rate this month.  If oil prices can stay around this level it would take a lot of pressure off the Fed to raise rates and give more time for financial markets to stabilize.

The Federal Reserve announced today that it was extending the emergency loan program for investment banks until January 30, 2009.

“The U.S. is pulling out all the stops here to make sure we don’t have a terrible downturn or a collapse in the financial system,” said Allen Sinai, chief global economist at Decision Economics in Boston. “There isn’t anything else the Federal Reserve can do but to keep pumping liquidity into the system.” 

When financial markets were in turmoil, the Federal Reserve opened up the discount window to investment banking firms.  Though normally reserved for commercial banking institutions, the fed took the unprecedented action in order to restore confidence to investors and avoid the run on funds that brought down Bear Stearns in March.

The credit crisis has gone on much longer than what many officials at the Fed were hoping.  The problem of inflation and rising energy prices has been an ever growing concern but it takes a back seat to the possibility of a financial meltdown.

Did you notice how fast the federal government acted in defusing the Fannie Mae and Freddie Mac situation?  In a less than three week time frame we went from fears of insolvency to a signed housing relief bill.

The government is beginning to see that monetary policy alone will not be enough to see us through this economic downturn.  The Federal Reserve also needs to do whatever it takes to combat the perception that they are starting to lose their handle on the situation.

Earlier today, securities firm Lehman Brothers posted a $2.8 billion loss for the second quarter, much larger than analysts were forecasting.  The company also announced plans to raise $6 billion in new capital from the sale of stock to cope with their exposure to the residential mortgage market.

Despite their plans to raise additional capital,  Fitch downgraded them to AA- from A+ while Moody’s changed their credit outlook to negative and is considering doing the same for the other investment banks as more writedowns are expected for the sector.  Trouble with the bond insurers isn’t helping matters as a ratings downgrades for their insured bonds will lead to additional writedowns for the companies that hold them.

The financial sector is continuing efforts to de-leverage themselves but are forced to sell highly illiquid assets in an increasingly depressed marketplace.  Foreclosures and delinquencies have also continued to climb as the housing market worsens.

There are serious doubts in the minds of investors for when the sector will return to profitability.  With the securitization market all but dead, the once highly profitable originate to distribute model for mortgages has ceased to be viable.

Financial stocks have fallen recently with the Fed starting to place more emphasis on inflation and sending signals to the market of a future rate hike.  European central banks are also considering raising rates which would further depress the dollar if the Fed doesn’t do the same.