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Why US Interest Rate Cuts if GDP is Growing by 5%?

Economics / US Interest Rates Dec 09, 2007 - 01:00 AM GMT

By: Andy_Sutton

Economics Overall, the Federal Reserve must be given decent marks for keeping up appearances in the wake of the onset of the largest credit crisis in US history. For the situation is now ubiquitous, wreaking havoc in virtually every market. True to form, the Fed has continued to modify its statements, perceptions all in an attempt to manage the public's confidence in the fact that yes, they are still in control of the economy. There have been, however, an increasing number of discrepancies and important issues emerging over the past several weeks and some startling but expected developments.

GDP near 5% along with rate cuts

US GDP was recently reported to be growing at an annual rate of 5% in the third quarter of 2007. From a historical perspective, 5% is a pretty good growth rate, and indicative of a healthy economic expansion. The prudent question to ask then is why has the Fed already cut interest rates 75 basis points in the second half of the year with another 25 likely next Tuesday? Why has the discount rate been cut so aggressively? Why have massive injections of additional money into the banking system been necessary? While the former would indicate stable growth and prosperity, the latter is indicative of a massive resuscitation effort. Upon observation, the GDP numbers simply don't add up. Consumer spending (which accounts for around 70% of GDP) has been flat. Exports have risen in the environment of the falling dollar, but not at a 5% rate. Imports have been fairly steady as well. 

So where is the 5% figure coming from? Before the final GDP number is released, the nominal figure is ‘deflated' by the GDP price index. For example, let's say consumer prices rose at a 5% clip annualized during the third quarter and the nominal (unadjusted) GDP was 6%. In this case the real GDP growth would be 1%. The GDP deflator used during the third quarter was stated as .9%. While it is certainly open to debate as to the authenticity of the deflator, the mechanism for releasing ‘friendly' or ‘situation-specific' numbers can be observed rather easily. A deeper question would be if it is possible or likely to have a robust economy coexist with a massive credit crunch, particularly when the bulk of that credit crunch surrounds the source of much of the recent growth?

Bailout plan for distressed homeowners announced

The only surprise here is that the proposed bailout did not come sooner. The President today unveiled an agreement to freeze rates on some subprime loans, stating now that the fallout is a ‘source of concern'. The three options as outlined will be to freeze rates, allow refinancing into a fixed rate new private mortgage or a FHA-backed mortgage. This measure was supposedly adopted not only to protect the homeowners from foreclosure, but also to protect the value of the securities that these distressed mortgages back. The problem is a simple one: The mortgage bonds strewn around the world were constructed with the assumption that the rates on the underlying mortgages would increase. The prices paid for these bonds were predicated on that assumption. When this proves not to be the case, the value of the mortgage bonds is sure to fall, albeit to a lesser extent than if the mortgages were to default. 

It is obvious that the government is doing whatever possible to protect the consumers' ability to spend. However, this bailout does nothing to address the rising inventories of homes, falling prices, and an estimated 600,000 homeowners who will not qualify for assistance. Moreover, forcing institutions to take on additional credit risk in the form of guaranteed loans for otherwise unqualified applicants will only pile additional risk onto an already distressed market.

In my view, we should not be assisting anyone. Adults made conscious choices. “I didn't know” is not an excuse. Our economy desperately needs cleansing. The rapidly increasing foreclosures, while causing pain, would have aided in the cleansing process. Government is now intervening to prevent this pain from taking place. This will pave the way for increased credit expansion, more inflation and more stress for consumers; even those who have been diligent about their financial decisions.

Canada, England, Middle East line up to support the faltering dollar

This week the both the Bank of Canada and the Bank of England reduced rates. In Canada, the benchmark rate was cut 25 basis points to 4.25%. England also reduced the benchmark rate by 25bp to 5.75%. The rationale behind the move was that inflation in Canada wasn't growing fast enough. The Canadian people should be thankful that their banking officials are so vigilant in protecting them from the awful consequences of deflation (sarcasm mine). The Bank of England tossed aside inflation concerns in favor of protecting economic growth in the midst of increasing costs of credit and falling home prices. 

The Middle East also decided earlier this week to maintain currency pegs in support of the dollar. Interpreted, this means that they will devalue and inflate their currencies for the purposes of supporting ours. While some would view these developments as positive for the dollar, I view them as negative for savers the world around. Unfortunately, this race to the bottom will make it harder for investors in the United States to find meaningful proxies by which to compensate their portfolios for the dollar's loss of purchasing power.

Contrary to the popular belief on Wall Street and in Washington that the credit fiasco is contained and under control, the situation is anything but. Bailout plans for banks, hedge funds, and now individual homeowners should underscore the breadth of this crisis despite the illusion that this whole mess is nothing but a small roadblock. The tools at the disposal of government for dealing with such a crisis are few given that economic pain is not acceptable in today's society. As prudent investors we must realize that these tools will be used and more importantly, how to protect our wealth in this environment.

In next week's piece, I am anticipating doing another cooperative piece with Atash Hagmahani relating to how valid investment opportunities are being removed from the table for average retail investors and how risk-reward dynamics have undergone a severe adjustment in recent months.

By Andy Sutton

Andy Sutton holds a MBA with Honors in Economics from Moravian College and is a member of Omicron Delta Epsilon International Honor Society in Economics. He currently provides financial planning services to a growing book of clients using a conservative approach aimed at accumulating high quality, income producing assets while providing protection against a falling dollar.

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