Should the Fed Cut Interest Rates?
Everybody on Wall Street is waiting for what the Federal Open Market Committee will do to interest rates when they meet on Sept. 18. The Federal Funds Rate options market now implies a 50% probability for a .50% cut and a 30% probability for a .25% cut. The probability for the Fed Funds Rate remaining unchanged is less than 10%.
[Source: Federal Reserve Bank of Cleveland, as of Sept. 9, 2007.]
Should the Fed lower interest rates? I think they shouldn't.
First of all, the Fed stated again and again in the past they wanted to curb inflation. They can't declare victory yet. Inflation isn't low. The Consumer Price Index in December 2006 was 201.8. It was 208.299 as of July 2007, the latest available data point. This means for the first seven months of this year, inflation was 208.299 / 201.80 – 1 = 3.22%. 3.22% inflation in seven months is terrible. If this trend continues, we will have annual inflation rate above 5%. That's simply too high. Inflation isn't under control yet. The Fed shouldn't let their guard down.
Second, the economy is doing fine. GDP growth is healthy. Unemployment is low. The latest jobs number is a one time glitch. Except for the mortgage market, the rest of the economy is doing well. Apple's iPhone still sells like hot cakes, which means consumer spending isn't weak. The economy is doing fine on its own. It doesn't need stimulating. There's no need to cut interest rate.
Moreover lowering interest rate now will send the wrong signal. Wall Street wants a rate cut so their risky subprime mortgages will be worth more because bond prices go up when interest rates go down. Cutting the interest rate now will let the subprime lenders off the hook easily. We can't have the Fed come to the rescue every time there is a stock market sell off. Or else they will just take on more and more risks and expect to be bailed out by the Fed. Many people believe that the Fed's lowering the interest rate all the way down to 1% during the most recent bear market planted the seeds for the housing market bubble and the current subprime problem. I agree with that assessment. The Fed panicked. They cut the interest rate too low and raised it too slowly after the short recession was over. For a great article on how the Fed's policy led to the easy credits and today's subprime problem, please read How Credit Got So Easy And Why It's Tightening from the Wall Street Journal.
Will the Fed cut interest rate in their September 18 meeting? Given that the market predicted a less than 10% probability of the rate not changing, I'd say they probably will cut it. The market participants collectively are usually a lot smarter than anybody else. But I'll be very disappointed if the Fed caved in to pressure from Wall Street. Even if the Fed thinks the economy needs some boost, they should wait until their October meeting. Waiting merely one month won't hurt the economy. But it will send a strong signal to Wall Street and politicians that the Fed makes its decisions independently. The Fed is responsible for the economy. It's not responsible for putting a floor under the stock market. They should make that point very clear.
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