Was this a Smart Move?

The Federal Reserve decided to cut the federal funds rate by 50 basis points form 5.25% to 4.75% and lowered the discount rate by 50 basis points from 5.75% to 5.25%. The vote was unanimous in both cases.

Was this a smart move by the Fed under the helm of Ben Bernanke or could it have longer-term negative impacts on the U.S. economy?

Most investors got a pleasant surprise from Mr. Bernanke but this could back-fire and lead to more problems in the future.

Who will benefit from the rate cut?

• The consumer is supposed to benefit
• Businesses are supposed to benefit
• The economy is supposed to benefit

But will they benefit?

The consumer is supposed to benefit as the cost of borrowing will be decreased and it is supposed to boost consumer confidence and therefore increase consumer spending.

Here are some things to consider:

• Those consumer which are hurt by the credit crisis will continue to feel the cash crunch
• Those consumers which have not felt as much of an impact during the current credit crisis may fear that it could catch up with them and therefore decrease rather then increase spending in order to boost savings.
• Most consumers are overextended and carry a higher debt toll then they can afford. To increase that debt makes no sense.
• Consumer confidence won’t rebound as quickly as it faded as it takes time for trust in the economy to redevelop.
• The housing meltdown is not over yet and will continue to deteriorate
• A report this morning shows an increase in deficiencies at car loans which suggest that the credit crisis expands rather then contracts.

Businesses are supposed to benefit as the cost of borrowing will decrease and access to credit will be easier. The available credit will be used for expansion and therefore fuel the economy and create jobs.

Here are some things to take a look at:

• If the consumer slows down most business will downsize rather the expand
• The labor market is tight at the moment and any further short-supply could fuel wage-based inflation
• The U.S. economy has weakened and the need or opportunity to expand are not great in the current environment

The economy is supposed to benefit from an increase in consumer spending, which accounts for roughly 2/3 of economic activity, and an increase in business activity.

Consider the following points:

• The consumer may not expand as many believe but rather increase the savings rate
• Once consumer spending slows business will rather contract then expand
• Inflation should not be ignored and the Fed mentioned inflation in its statement which should rule out any further rate cuts.
• Commodity prices have been at elevated levels and currently spiked to new record highs. This will show up in inflation reports in the coming weeks and end the recent slowdown in inflation readings. This hold true for hard and soft commodities.
• The economy is currently experiencing a slow-down and the rate cut earlier today shouldn’t be sufficient to reverse the current trend
• Price reading on reports form the Empire State Index to the Philly Fed Survey to the NAPM-Chicago and both ISM surveys show that prices paid components remain near record levels and expectations six months ahead suggests that companies expect high prices to remain in place. The two choices which companies have, either not to pass expenses on to consumers and feel a direct impact on their bottom line or to pass on higher prices and add to inflation and inflationary expectations, are a negative for the economy
• The dollar will continue to weaken which will have a direct negative impact on foreign investment in the U.S. and the trade deficit which is likely to increase over the next few months

The above are just a few points to consider before a judgment in regards to the economic wisdom of yesterday’s rate cut should be made.

The Federal Reserve should be concerned about long-term price stability rather then to bail out investors from the credit crunch and housing problems.

Yesterday’s rate cut may have a bigger long-term negative impact on the economy then a temporary short-term benefit.

Economic data in the next weeks should be closely watched to see if the rate-cut yesterday will have the desired impact.

Conclusion:

Yesterday’s rate cut, which was more then most have expected, may not yield the expected positive results the Fed has hoped for and although cheered by investors yesterday could have a negative economic impact during the next few months.

One thing should be clear:

If the negative economic impact will come to fruition in the next three to four months and the Fed is forced to hike rates within the next six months, a move that currently seems not very likely but given the fact that inflation and inflationary expectations have been embedded in the economic system for an extended period of time and considering the recent move in hard as well as soft commodities in addition to yesterday’s rate cut, the economy is definitely in danger of heading for a recession.

I think it was definitely a bad move - Bernanke was previously stating that it's the Fed's job to fight inflation, not rescue bad lenders from their own woes. All that's really happened is the prolonging of the inevitable in my opinion.


To me it's down to 2 options:

1. Do you want to rip the band-aid off quickly, with a short-sharp pain?
2. Do you want to pull the band-aid off very slowly, prolonging the agony and uncertainty?

I figure the Fed have opted for the latter - possibly because we're winding up for new elections, and the political fall-out of a sharp economic shock would be intolerable.