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July 21, 2008

The Wreckless Federal Reserve

There’s No Room for ‘Proactive’ in Monetary Policy

As our economy teeters on the verge of both a recession and stagflation, the Federal Reserve should look no further than its own doorstep for the responsible party to most of our economic woes. The Fed’s desire to be “proactive” as opposed to reactive has placed this country in a dangerous position. Our economy could easily become the worst in nearly three decades!

In order to make my point, I would like to start by explaining monetary policy. Unlike fiscal policy, which is government spending, monetary policy is the management of a country’s money supply. When the money supply increases, it is usually to stimulate growth (avoid recession) and interest rates fall. When the money supply decreases, it is usually to fight an overheating (too much growth, which can cause collapse) in an economy and interest rates rise.

Interest rate behavior based on the monetary factors above can be quite predictable, unless you have inflation. Inflation plays a major role, not only in how much we spend for consumer products, but on interest rates as well. If the inflation rate is 3%, a bank is not going to give you a mortgage for 2.5% because the bank would be getting paid with dollars that depreciate at a greater rate than the return. Therefore, higher inflation causes interest rates to increase.

Now that we have an idea on what monetary policy is, let’s review the Fed’s behavior over the past decade. In 2001, the economy was slipping into a recession, when suddenly, the terrorist attacks of 9-11 occurred. The Fed, believing that economic conditions would become much worse, cut interest rates to practically nothing, pumping all kinds of money into circulation to try and get the economy stimulated.

As we now know, things were not that bad, and the banks took advantage of the excess cash. They began lending money out to anyone willing to borrow. $0 down mortgages to people with no credit history or unstable employment began to become popular. Money was cheap (an expression used when interest rates are low) and banks wanted to lend as much of it out as possible to increase their returns.

The economy was growing much faster than expected in 2004 and 2005, so the Federal Reserve incrementally raised rates in eighteen straight sessions. Those who got adjustable rate mortgages watched their monthly payments nearly double. Suddenly, the most irresponsible of home owners began defaulting on their loans and banks were foreclosing on homes. To quantify, banks lent at least $500 billion in bad loans. Now, when a bank makes a bad loan that it cannot get back, what happens? The bank has to write the loan off of its balance sheet, thus decreasing assets, equity, and earnings. However, liabilities (which is the amount owed to other banks and to consumer deposits) did not decrease. Do you see where the banks began to get in trouble?

By last August, distressed banks began popping up all throughout the U.S. Banks were taking control of houses (which are assets), but writing off the mortgages at 30% more than what the homes were worth. To make matters worse, no buyers could be found for these homes. Banks needed to convert their assets into cash and quickly. In stepped the Federal Reserve.

When the Federal Reserve increases interest rates, it removes money from the money supply by selling government bonds. Banks buy these bonds in exchange for the money that is being pulled out of the market. Now, the Fed needs to increase the money supply and gives cash to the banks, in return for the bonds they sold to the banks. This was designed to provide the banks with the liquidity they needed. The result of all this is lower interest rates.

It sounds like the Federal Reserve acted practically to meet the needs of the economy, so why do I believe the Fed overreacted?

When the Federal Reserve cuts interest rates, it can do so in practically any increment it wishes. Usually, rates are cut (or increased) in .25, .5, .75, or 1% increments. The Federal Reserve’s first cut was for .50% in August, followed by a .75% and a .25% cut within one week of each other in January. In the end, the Federal Reserve interest rate (known as the Fed Funds rate) went from 5.25% to 2% in about six months. This is way too quick of a response.

First off, the economy was not in a recession while the Fed continued to cut rates. Most economists believed that the economy was two quarters from recession when the first cuts started in August, which is acceptable for a monetary body to act. However, the Fed did not wait to quantify the reactions on the economy before making further cuts. They continued to cut rates as if their previous cuts were not stimulating the economy. How were they to know? The data had not come in yet.

When monetary policy is changed, it takes six months for the effects to begin being felt across the entire economy. This means that by the time the final cuts were taking place this spring, the Fed was just beginning to understand the effects of the August cuts. The Fed should have made the cuts and had the economy continued to deteriorate beyond their expectations, they could have continued to cut by .25%. This would have slowly and surely eased the credit crisis.

Instead, the Fed dumped 3.25% worth of cuts into our economy, and six months later there is no sign of better times. In fact, economists are predicting a further drift towards recession in the second half of the year. The Fed is left with little power to cut rates (only has 2% left) and a depleting economy.

To make matters worse, the Fed’s injection of the money supply drove down the value of the dollar on the world market. Now, the price of all imports (including oil) is up more than 20% on average year to date. This is where inflation comes into play. With rising prices and a less valuable currency, the consumer is able to purchase less and less thus causing demand to fall, production to fall, and eventually, economic growth to fall. Currently, our inflation rate is over 7% if you include food and fuel. It was under 3% when the credit crisis started.

The Federal Reserve decided to act proactively to stop a crisis that nobody (including this writer) could understand. Had the Fed taken a reactive approach, it could have adjusted the money supply as conditions worsened beyond their expectations, and by smaller increments, to give themselves and the consumer more economic power and time to understand the full scope of the situation.

Finally, the whole purpose of the Fed’s cutting spree was to help the ailing banks and indirectly, the housing market. Thanks to high inflation, interest rates are back on the rise, which is making it harder for consumers to borrow and buy the homes that banks are desperately trying to sell. (See images at the top of the post for details).

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