Best of the Week
Most Popular
1. Investing in a Bubble Mania Stock Market Trending Towards Financial Crisis 2.0 CRASH! - 9th Sep 21
2.Tech Stocks Bubble Valuations 2000 vs 2021 - 25th Sep 21
3.Stock Market FOMO Going into Crash Season - 8th Oct 21
4.Stock Market FOMO Hits September Brick Wall - Evergrande China's Lehman's Moment - 22nd Sep 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.How to Protect Your Self From a Stock Market CRASH / Bear Market? - 14th Oct 21
7.AI Stocks Portfolio Buying and Selling Levels Going Into Market Correction - 11th Oct 21
8.Why Silver Price Could Crash by 20%! - 5th Oct 21
9.Powell: Inflation Might Not Be Transitory, After All - 3rd Oct 21
10.Global Stock Markets Topped 60 Days Before the US Stocks Peaked - 23rd Sep 21
Last 7 days
Investing in the METAVERSE Stocks Universe - 8th Dec 21
Stock Market Sentiment Speaks: I Expect 15-20% Returns For 2022 - 8th Dec 21
US Dollar Still Has the Green Light - 8th Dec 21
Stock Market Topping Process Roadmap - 8th Dec 21
The Lithium Breakthrough That Could Transform The Mining Industry - 8th Dec 21
VR and Gaming Becomes the Metaverse - 7th Dec 21
How to Read Your Smart Meter - Economy 7, Day and Night Rate Readings SMETS2 EDF - 7th Dec 21
For Profit or for Loss: 4 Tips for Selling ASX Shares - 7th Dec 21
INTEL Bargain Teck Stocks Trading at 15.5% Discount Sale - 7th Dec 21
US Bonds Yield Curve is not currently an inflationist’s friend - 7th Dec 21
Omicron COVID Variant-Possible Strong Stock Market INDU & TRAN Rally - 7th Dec 21
The New Tech That Could Take Tesla To $2 Trillion - 7th Dec 21
S&P 500 – Is a 5% Correction Enough? - 6th Dec 21
Global Stock Markets It’s Do-Or-Die Time - 6th Dec 21
Hawks Triumph, Doves Lose, Gold Bulls Cry! - 6th Dec 21
How Stock Investors Can Cash in on President Biden’s new Climate Plan - 6th Dec 21
The Lithium Tech That Could Send The EV Boom Into Overdrive - 6th Dec 21
How Stagflation Effects Stocks - 5th Dec 21
Bitcoin FLASH CRASH! Cryptos Blood Bath as Exchanges Run Stops, An Early Christmas Present for Some? - 5th Dec 21
TESCO Pre Omicron Panic Christmas Decorations Festive Shop 2021 - 5th Dec 21
Dow Stock Market Trend Forecast Into Mid 2022 - 4th Dec 21
INVESTING LESSON - Give your Portfolio Some Breathing Space - 4th Dec 21
Don’t Get Yourself Into a Bull Trap With Gold - 4th Dec 21
GOLD HAS LOTS OF POTENTIAL DOWNSIDE - 4th Dec 21
4 Tips To Help You Take Better Care Of Your Personal Finances- 4th Dec 21
What Is A Golden Cross Pattern In Trading? - 4th Dec 21
Bitcoin Price TRIGGER for Accumulating Into Alt Coins for 2022 Price Explosion - Part 2 - 3rd Dec 21
Stock Market Major Turning Point Taking Place - 3rd Dec 21
The Masters of the Universe and Gold - 3rd Dec 21
This simple Stock Market mindset shift could help you make millions - 3rd Dec 21
Will the Glasgow Summit (COP26) Affect Energy Prices? - 3rd Dec 21
Peloton 35% CRASH a Lesson of What Happens When One Over Pays for a Loss Making Growth Stock - 1st Dec 21
Stock Market Sentiment Speaks: I Fear For Retirees For The Next 20 Years - 1st Dec 21 t
Will the Anointed Finanical Experts Get It Wrong Again? - 1st Dec 21
Main Differences Between the UK and Canadian Gaming Markets - 1st Dec 21

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

The Fed's Interest Rate Dilemma: Rescue the US Housing Market, or Feed the Poor?

Interest-Rates / US Interest Rates Apr 29, 2008 - 06:50 AM GMT

By: Martin_Hutchinson

Interest-Rates

Best Financial Markets Analysis ArticleAt their two-day meeting that starts today (Tuesday), U.S. Federal Reserve policymakers will have to grapple with a moral choice that is well beyond the pay grade of central bankers - choosing between the financial stability of U.S. homeowners and world hunger.

That's not an exaggeration. Interest-rate policy normally only affects the world economy at the margin, but it has now been so expansionary for so long that the Fed's interest-rate strategy has turned into a moral dilemma of sorts. In short, the central bank's monetary policy will likely determine whether millions of U.S. homeowners lose their homes or millions of the world's poor starve.


Let me explain…

Expansionist Policies Lead to Market Bubbles

The Federal Reserve has been pursuing an expansionary monetary policy - growing the M3 money supply much faster than Gross Domestic Product (GDP) - since 1995. This has yet to result in U.S. consumer price inflation because a very powerful deflationary force - the introduction of cheap and readily available global communications through the Internet - has counteracted it.

Even though prices of domestically produced goods were increasing, the prices of many goods and services dropped as they became sourced from India (software services, for instance) and China (clothing, for example).

The result has been asset bubbles in both U.S. stocks and then U.S. housing, but without an accompanying big increase in consumer price inflation. Since last September, the Fed has moved to make monetary policy even more expansionary, cutting the benchmark Federal Funds rate six times to bring it down to 2.25% from its starting point at 5.25%, and pumping massive amounts of money into the banking system to bail out the banks that had lost money on subprime loans.

Most experts believe the central bank will cut rates again tomorrow (Wednesday), most likely taking the Fed Funds rate down another quarter point, to an even 2.0%, upon which the central bank will take a rate-reduction breather.

From the point of view of the U.S. housing market, Fed Chairman Ben S. Bernanke should keep cutting interest rates. Low short-term interest rates have a doubly beneficial effect on housing:

  • First, low-level short-term rates tend to reduce long-term mortgage rates, while at the same time making banks more profitable. This increases banks' readiness to lend for housing and reduces the interest rate on mortgages, making finance easier to get and cheaper for prospective homebuyers.
  • Second, lower interest rates cause inflation. Consumer-price inflation is currently running at an annualized rate of about 4% over the last 12 months, so interest rates at about 3.6% for 10-year Treasuries and 2.25% for the Fed Funds rate are now significantly below the U.S. economy's inflation rate. That means savers are getting an even worse deal than they usually get. It also means inflation is almost bound to accelerate: By definition, if borrowing costs are actually less than zero, people will find ways to borrow and then will waste the money they have borrowed.

The bottom line : Inflation is likely to rise rapidly towards the 10% level in the months to come .

The Fed's Inflation-Fueled Rescue Plan

In most quarters, inflation is viewed as a four-letter word. But in a housing market where home prices are locked in a downward spiral, inflation is actually very good. For instance, should inflation spike to 15% and stay there for all of 2009 - while the U.S. economy remained in decent shape - then wages and prices could be expected to increase by 15% in 2009.

Additionally, the dollar would drop in value against other currencies that did not experience this burst of inflation. That would make housing relatively cheaper both for U.S. homebuyers (house prices would be a smaller multiple of earnings) and for foreigners (fewer European euros, Japanese yen or Chinese Renminbi needed to buy U.S. houses). The decline in housing prices would stop - and probably reverse - and the tsunami of mortgage foreclosures also would slow. The reason: Home mortgages would cease entering the "negative equity" situation in which it is cheaper for borrowers to walk away from both their home and mortgage than to keep making the payments.

If we're only considering the housing market, Bernanke should lower interest rates as fast as possible. It will cause inflation , but he may well believe that a further series of home-price declines would cause so many problems in the home-mortgage market that moderate inflation is preferable.

Unfortunately, we don't live in an economic vacuum, and Bernanke and his fellow Fed policymakers have much more to consider than just the travails of the U.S. homeowner.

You see, in addition to U.S. inflation and housing, Bernanke's monetary policy has affected the world commodity and energy markets - and in a huge way. That's why oil is now five times more expensive than it was in 2002, and is likely headed higher , still, before consumers get a reprieve.

But it was the rate-cutting campaign the Fed embarked upon last September that's inflicted the real damage. Fed policymakers fired their first shot at the Fed Funds rate on Sept. 18, when it took short-term rates from 5.25% to 4.75%. On that day, oil closed at $82 per barrel, gold at $770 per ounce and the Reuters-CRB Index (CCI) of commodity prices was at 435. The flood of money poured into the system by the Fed and other central banks in the last seven months has had the anticipated impact: As I write, oil is at $118, gold is at $890 and the CCI Index has reached 544.

Bernanke's low interest rates, and the equivalently low interest rates in many other countries of the world, affect commodity prices in three ways:

  • First, they cause economic activity to increase more rapidly than would normally be possible. In the long run, this would produce benefits (if it were not succeeded by a period of above-normal rates to quell inflation). In the short run, it causes consumption to outrun production, producing shortages.
  • Second, low interest rates increase the amount of liquidity in world markets. For proof, just look at one statistic - world foreign exchange reserves have increased by nearly 17% annually over the past 10 years , double the growth rate of global GDP. That liquidity causes prices to rise, especially in energy and commodities markets, where a freely fluctuating market exists.
  • Third, low interest rates encourage the creation and expansion of speculative funds (such as hedge funds), which seek to capitalize on escalating commodity prices, which has the effect of sending overall prices even higher still.

Bail Out Homeowners (or) Feed the Poor

While Americans consume only moderate quantities of raw commodities as a percentage of total consumption (there is little, if any, iron ore in an Apple Inc. ( AAPL ) iPod, for instance), for poor people in the Third World commodities still account for the bulk of their budget. While increases in energy and metals prices simply raise the cost of living, food-price spikes are much more serious, since they directly and significantly erode the living standards of the world's poor.

Still more disturbing is the fact that the recent surge in food prices (which has been extreme, rice alone having trebled in price in the last year) has caused the beginnings of a breakdown in the world's free trading system in food. Rice exporters such as Egypt, Indonesia and Vietnam are restricting, or even prohibiting, the export of certain kinds of rice, moves they've made to try and keep prices of that commodity down in their home markets.

Since many poor countries such as India also subsidize basic food prices to limit urban unrest, national budgets are being thrown out of kilter.

At the margin, for the very poorest people in the least competently run countries, the result of this food-price surge is likely to be starvation.

New crop plantings will alleviate the problem within a year, but for many, that will be too late: You can defer an automobile purchase until next year, but you can't stop eating.

Bernanke no doubt hopes that he can keep interest rates low and thereby stimulate the U.S. economy and solve the housing problem, wringing out any inflationary results by pushing rates higher once housing has stabilized and the U.S. market has moved back onto a growth track. That appears excessively optimistic. A prolonged period of low interest rates will perpetuate the bubbles in energy and commodities, which will have two effects.

In the United States, it will firmly establish an inflation level of 10% or more, which will require a wrenchingly difficult recession to emerge from, as it did in 1979-82, thanks to a managerial miracle by then-Fed Chairman Paul Volcker.

But in poorer countries, a long run of low interest rates will not only cause inflation and hardship, it will bring starvation as food prices soar well beyond the means of the poor. Hoarding will result, until finally all the world's food-market mechanisms end up collapsing.

So if the central bank does cut interest rates tomorrow afternoon, think twice before you cheer.

News and Related Story Links :

By Martin Hutchinson
Contributing Editor

Money Morning/The Money Map Report

©2008 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email: customerservice@moneymorning.com

Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investment advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

Martin Hutchinson Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in