Tuesday, March 18, 2008

Why the Fed Rate Cut Hurts You

The fed, as expected, cut the rate 0.75%.  This was slightly less than a lot of people were betting on as the fed funds future rate actually seemed to imply a 1% expectation.

That being said, the market celebrated with a gigantic day with the major indexes up over 3%.  So it's time to celebrate, pop the champagne, and go running into the market right? The economy is saved! Not so fast.

The feds action definitely helps the banks who got themselves into a mess by taking the easy money and making some bad loans.  The Fed's actions are squarely to ease the credit crunch which is hammering the financial markets. However, the fed has no control over what the banks do with the easy money.  And by all indications the banks aren't passing on the money to their customers.

Despite the Fed rate cuts, the cost of mortgages are actually going up.  The
average 30 year fixed mortgage is just under 6%.   This despite the fact that the 10 year note currently stands at 3.5%.  For those that don't see the significance, this 2.5% difference (referred to as the spreads) is normally only 1.5%.  The spread represents the risk a bank is willing to take and the widening of the spread shows that they aren't willing to take very much.  Add that to the fact that they are owning willing to lend to those with high credit scores, and you can see how this isn't helping the average American very much.

So what are the banks doing with the easy money?  There is actually an arbitrage opportunity here since they can borrow the money and invest it in higher yielding government bonds.  Of course, you can't do this since you can't borrow from the Fed.  Sucks huh?

But at least the Fed cut isn't hurting you right?  Saving the banks is a good thing isn't it?  Sure if you don't mind higher inflation and a weaker dollar (causing the price of imports and commodities like oil to rise).   If you don't mind taxpayer dollars being used to bail out billion dollar banks.  If you believe that the way to fix the problems caused by easy money is to throw more easy money than the fed is doing the exact right thing.

1 comment:

  1. Yes, the Fed cut in interest rates hurts us, because this type of economic policy just encourages bad habits too much spending and borrowing and not enough saving and investing.

    Bailing out the banks and mortgage companies isn't helping us. All it does is contribute to the devaluing of homes. It sucks to have a $300,000 mortgage on a home valued at $280,000.