Being Street Smart 9/23/7

BEING STREET SMART
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Sy Harding

UNINTENDED CONSEQUENCES?


Fed Chairman Ben Bernanke was destined to be damned if he did, and damned if he didn’t, when it came to this week’s decision of whether or not to cut interest rates. But he has to be disappointed by some of the unintended consequences, as well as the timing of remarks by his predecessor, former Fed Chairman Alan Greenspan.

I don’t think the Fed had any choice. I’ve been saying for some time that it was getting too far behind the curve if it was going to try to do something about the slowing economy.

However, in playing catch up this week with aggressive 0.5% cuts in both the Fed Funds rate and the Discount Rate, the Fed created new concerns and questions.

Some of the questions were expected. Does the Fed know something it didn’t know before that caused it to reverse course so suddenly? Was it sending an unintended signal to lenders and borrowers that the Fed will always be there to bail them out if their speculative excesses get them in trouble? Is the Bernanke Fed going to follow the path of the Greenspan Fed in allowing easy money to create bubble after bubble?

There does seem to be agreement on one issue. If a recession is coming the Fed is almost powerless to do much to prevent it at this point. It takes six to twelve months for interest rates to filter down and affect the economy, and a 0.5% cut wouldn’t be enough to do that even then. It has almost always required a series of cuts over a period of time before any results are seen.

Then there has been what must surely be unintended consequences of the decision.

As the Fed cut short-term rates, long-term interest rates have begun to rise. It showed up immediately in higher yields (therefore lower prices) for long-term bonds. Bonds are worried that the Fed has caved in on inflation, which will now get out of control. That worry has gold, the historically accurate predictor of inflation, soaring, while bonds and the U.S. dollar plunge, the already weak dollar plunging to new multi-year lows.

Higher long-term rates are also likely to result in higher mortgage rates. If so, that would worsen rather than improve the outlook for the housing industry, and economy, causing the rate cuts to backfire at least from that direction on its intended purpose of helping the economy.

Yet, it’s not enough that the Bernanke Fed has to worry about these unintended results of its rate cuts. Along comes none other than former Fed Chairman Greenspan, his presence everywhere in the media promoting a new book.

Greenspan’s latest pronouncement came Friday when he said in an interview that low interest rates over the last 15 years created the housing bubble, but that the Fed discovered it was powerless to bring the bubble under control. Greenspan’s timing of choosing this week to point out the Fed’s most recent failures did not provide support for Bernanke’s efforts to spread confidence in the financial community regarding how this week’s Fed’s decision will work out. Greenspan said, “The Federal Reserve began a series of interest rate increases in 2004. We were hoping to bring the speculative excesses in the real estate sector under control. We failed. We tried again in 2005, and failed again.”

But Greenspan’s most unsupportive remark for Bernanke’s efforts to reverse the problems in the housing industry was his statement that housing, “is a difficult situation; there is a tremendous overhang of unsold homes. . . . So far, prices have dropped only slightly. . . . prices are going to fall much lower yet.”

Meanwhile, the extent of the problems still out there in the financial sector remains unknown. Or as Art Cashin, Director of NYSE Floor Trading for USB, puts it, “We still don’t even know what it is that we don’t know.”

For instance, as a result of the plunge in bond prices, it was reported Friday that TCW, a large bond fund management firm, was forced to begin selling the bonds that are the underlying assets in a $3.2 billion collateralized debt obligation (CDO) it manages for CitiGroup, as the bonds backing the CDO collapsed. So there we are with still another type of debt-backed security causing problems, with no indication of how many other financial firms might be similarly affected.

James Hamilton, economics professor at the University of San Diego, says, “The bond market seems to view the Fed’s rate cut as having surrendered some its long-run inflation goals.”

Of that prospect, Howard Simons of Bianco Research writes, “Over the intermediate and longer-term, inflation will poison all financial assets as it always does.” That is a reflection on the fact that historically both stocks and bonds have abhorred inflation.

It is apparent that the Fed’s rate cuts were not an all-is-well signal.



Sy Harding is president of Asset Management Research Corp., publishes the Street Smart Report newsletter, and a free daily Internet blog at www.SyHardingblog.com. He also authored the 1999 book Riding The Bear – How To Prosper In the Coming Bear Market.