Federal Reserve & Interest Rates

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.

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.

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.