September 18, 2007

Posted on October 15, 2007 by David Laidlaw 

Board of Governors of the Federal Reserve System (Release Date 9/18/2007):

The Federal Open Market Committee decided today to lower its target for the federal funds rate 50 basis points to 4-3/4 percent.

Economic growth was moderate during the first half of the year, but the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally. Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.

The above first two paragraphs of the news release from the Federal Reserve should be put in context to understand what caused the government to respond so drastically to the recent volatility in the markets. We believe the rate cut, which caused the stock markets to automatically gain 3%, is not a panacea that will allow the economy and credit markets to avoid future problems, but instead may contribute to higher inflation.

As discussed in previous commentaries, the extended period of low interest rates and ongoing government tax subsidies such as the mortgage interest deduction and capital gain exclusion caused a real estate bubble. This bubble attracted aggressive mortgage brokers, real estate speculators and others who pushed up housing prices beyond reason. The bubble is now popping and many borrowers are having trouble servicing their debt.

Increasing loan delinquencies have had numerous financial repercussions. The majority of low quality mortgages were pooled and packaged into bonds. Prices for these bonds have fallen precipitously as the market has assessed a much greater degree of risk inherent in these bonds than initially expected. Hedge funds at Bear Stearns and elsewhere that invested in these assets have failed since the funds’ own debt exceeded the value of the underlying bonds in its portfolio.

The presence of these bonds in the financial system has also triggered a credit crunch. Many banks and other financial institutions have been much less likely to lend to each other since they are afraid that their counterparties will not be able to repay their debts due to the large amount of low quality debt that they own. Short-term interest rates such as LIBOR also increased dramatically.

We believe that the Federal Reserve acted properly by initially lowering its discount rate on August 17th, a separate action from the federal funds rate cut a month later. The Federal Reserve and the European Central Bank sent a message to the banks that they could borrow from the government to meet their near term obligations. This response was necessary to allow the credit markets to function properly again.

The second reduction by the Federal Reserve when it lowered its target interest rate on September 18th was intended to prevent a recession as indicated explicitly in its press release quoted on the first page. Whether or not the housing and credit problems cause a recession is an open question.

Initially, we believed that the credit problems were financial events and that they would not have a significant impact on the economy. However, the August jobs report showed that 4,000 jobs were lost even though economists forecasted the economy would create over 100,000 new jobs. This negative economic news should be balanced against strong retail sales reports and growth in the export sector resulting from continued expansion in Europe and Asia. Our view is that economic growth will slow, but that we will not experience negative growth.

There are two main problems with the Federal Reserve’s decision to lower interest rates. The first is that the government’s response encourages the wildly aggressive speculation that caused all of the problems in the first place. Since fewer housing speculators and aggressive hedge fund managers will fail, these individuals will be encouraged to take added risks since the government has indicated that it will bail them out if the markets get choppy.

The second problem with the interest rate cut is that it significantly increases the likelihood that inflation will increase in the future. Since September 18th, interest rates and gold prices have increased and the dollar has reached a historical low of more than $1.40 per Euro. A cheaper dollar makes our exports more attractive, but weakens our buying power as import prices rise. All commodity prices, including oil, metals and agricultural goods have risen. These higher input prices drive up the cost of finished products and cause inflation.

Fortunately, the housing slump and credit problems are occurring during a period when corporate profits are generally strong and the equity markets are not overly valued. Given our inflation concerns, we will continue to weight portfolios to those companies and sectors that will be less impacted by inflation.