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Friday, October 10, 2008

The Fed's Miscalculation?

On Wednesday morning, the Federal Reserve lead the central bank apparatus in cutting the major rates. This was supposed to calm the markets and open up borrowing by banks in order to create lending from banks. The verdict on this action for the last three days maybe a resounding failure. Understanding the movement of interest rates and their effect on outside forces is one of the most difficult tasks we face.

The Prime Rate and other so called central rates like LIBOR are what are called short term rates. Why? It's because they are used for short term borrowing, as little as overnight. How people view borrowing for the short term and the long term are of course totally separate issues. So, while the Fed may in fact have made it easier for banks to borrow from it and each other, the Fed may have at the same time made it more difficult for everyone else to borrow. That's because while banks often borrow for as little as overnight, businesses and consumers almost always borrow for much longer terms. Most business loans, home loans, car loans, and student loans are lent for years at a time.

What has been the effect of the rate cuts on long term rates? It has exploded long term rates in a relative short period. The ten year U.S. Treasury, which is in my opinion the best benchmark for long term rates, has gone up about four tenth of one percent since Wednesday. Mortgage rates have in effect gone up nearly one half of one percent. Prior to Bernanke cutting the central rate, we were on the brink of a new refinancing boom. The thirty year fixed rate mortgage was approaching 5.5%. Another couple days and we would have seen an explosion in refinancing as good qualified borrowers everywhere would have been able to get lower rates than they had locked in months and years ago. Instead, the mortgage rate has ballooned in response to his cut. Why? It's because low short term rates can be read as inflationary in the long term. Really low short term rates are almost always read as inflationary.

Think about what just happened. The market was melting down but this meltdown was at least having the happy effect of making most long term interest rates lower. Why? It's because normally there is what is called a flight to safety. When stocks are hurt, many folks move their money into bonds. Now, short term bonds like the three and six month Treasuries have gotten better but all other longer terms continue to get worse. That's because rather than calming the markets and creating borrowing and lending, all this rate cut did was give the market inflationary fears on top of fears of a recession.

Had Bernanke left well enough alone, what would have happened would have been an increase in applications for mortgages and soon enough even more buying. That's because mortgage rates would have continued to plummet while stocks were crushed. It was, after all, the refinancing boom that kept the economy from total disaster in 2001-2003. It could have once again lead us out of this problem. Instead, Bernanke, feeling he could do more, lowered the central rate so low that the market now fears inflation. As such, he has made borrowing more difficult for all those except banks and some businesses that also borrow in the short term.

So, what did Bernanke do? He has removed yet another avenue for recovery, low long term rates. Banks will now have more money to lend, and they will be even more motivated to lend. That's because the spread between short term lending rates and long term lending rates is bigger. Yet, the consumers that are one the end of those long term borrowing rates will now face higher rates than they did just three days ago. Of course, not only will that make borrowing more expensive but by extension it will decrease borrowing.

What was the motivation for this incompetence? Bernanke lowered the central rate to bring "confidence" in the market. Rather than using the word confidence he should have used the word hubris. Bernanke seems to think that he is all powerful and his utter failure over the last nine months is totally lost on him. The markets lack confidence because a whole lot of players made a whole lot of bad bets. Bringing confidence back to such a dynamic by simply lowering a rate is the height of hubris. The early verdict on this central bank rate cut is that it just poured gasoline on a large flame.

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