WASHINGTON, Sept. 24 (UPI) -- The Federal Open Market Committee Tuesday decided to keep its target for the Federal Funds rate at 1.75 percent, in a divided decision. They thus opted for caution, possibly concerned over the economic distortion that their previous rate cuts have produced.
In the short term one cannot disagree with their decision, nor with their accompanying statement that the risks in the economy are weighted mainly towards conditions that may generate economic weakness -- of course, the latter directly contradicts Fed Chairman Greenspan's Congressional testimony only two months ago, as well as in my humble opinion grossly understating the seriousness of the current economic position but hey, this is the public sector, you take signs of competence where you can find them. The decision was clearly a difficult one, since two FOMC members, Clinton appointee Edward Gramlich and Robert McTeer, Bush 41 appointee President of the Federal Reserve Bank of Dallas, wanted an immediate rate cut.
As the economy and the stock market continue to weaken, the Fed will doubtless cut rates further, possibly even by an inter-meeting cut, attractive because it carries more weight in the stock and bond markets. After all, there's another seven ¼ point rate cuts to go before the Fed hits the Japanese problem, with rates at zero and everybody holding physical cash instead of T-bills.
Interest rate cuts are supposed to generate their full effect over a 6-12 month period. Hence, since the last of the Fed's eleven cuts in 2001 took place on December 11, 2001, the full effects of the program should now be apparent.
So, where's the economic recovery?
It isn't here, of course. The Conference Board's Consumer Confidence data, announced Tuesday, showed a further drop in confidence, the fourth in succession, while UBS Warburg data showed chain store sales unexpectedly dropped 1.7 percent for the week. Gross Domestic Product increased sharply in the first quarter of 2002, but since then there has been a marked deterioration in the tone of the economy. The deterioration is not caused simply by falling asset prices, since the rise in house prices in 2002 has more than offset the decline in stock prices.
This does not mean that the Fed rate cuts have had no effect. However, they have produced not economic health, but distortion.
Take the housing market. This has been running at record levels since mid 2001, with mortgage refinancings exceeding their previous record by a considerable margin. The continued drop in long-term interest rates has caused mortgage rates to fall to a level not seen for many years, and led to a spike in refinancing.
The housing and refinancing boom was caused by Fed monetary policy, which allowed M3 money supply to grow at 10.0 percent per annum since November 2000. The extra money has not gone into increased economic activity, it has not (unlike the earlier excessive monetary growth in the 1990's) gone into the stock market, and it has not gone into inflation. Instead, it has gone into bond investments and into house purchases and prices.
It can be debated whether house prices now form a "bubble." They certainly show many signs of it, but on the other hand, even on the crowded East and West coasts, house prices are not as excessive, in relation to purchasing power, as they were in Japan in 1990, or are in London today. However the huge surge in mortgage refinancings, most of them of the "cash-back" variety, in which the borrower increases the size of his mortgage and receives cash, has had an equally large knock-on effect on consumer spending, causing it to remain far above normal recession levels -- 2001-2 is quite unlike any other recorded U.S. recession in this respect.
Cash-back mortgage refinancings are a jolt to the economy that cannot continue indefinitely. Sooner or later, long-term interest rates must stop dropping, and mortgage refinancings must slow. At that point, the artificial surge in consumer spending, which has benefited GDP in the short term, will also end. The home mortgage market, in short, is distorted, and when it ceases to distort itself further, the economy will slide.
The Treasury bond market's strength, too, is an artificial effect of Fed monetary policy that is by no means wholly healthy. The Federal budget has swung from a $127 billion surplus to a deficit of nearly $200 billion in only a year, and the deficit is clearly set to climb further. Inflation is rising and will be boosted further by the decline in the dollar, both that already taking place and that to come. Hence one would expect long-term interest rates to be on an upward trend. Instead, they have fallen to a level not seen since the Eisenhower administration, a period when the U.S. had no peacetime experience of inflation, and ran a consistent budget surplus.
The strength in bonds is partly caused by an inflow of cash from foreign investors seeking a safe haven, but also by a more sinister force: attempts by home mortgage banks to balance their books in the face of the mortgage refinancing bonanza.
When a mortgage is refinanced, the lender loses an asset while keeping the liability, thus unbalancing its portfolio. This has happened recently to an inordinate extent; as disclosed Monday, the huge mortgage bank Fannie Mae has a 14 month negative duration gap in its portfolio, compared with an expected maximum such gap, in either direction, of six months (in other words, its liabilities have a "duration" -- approximately, maturity -- fourteen months longer than its assets.) This means that Fannie Mae is heavily exposed to a decline in interest rates; it must find new assets, which inevitably will carry lower interest rates, to replace the loans that have been refinanced. To balance its book, Fannie Mae and the other mortgage banks are currently said to be buying Treasury bonds in large quantities, to lock in even the current low interest rates in case rates decline further.
If the Fed cuts rates further, the housing market, the mortgage refinancing market and consumer spending will once again receive a short-term boost. However, the yield on Fannie Mae's assets will fall still further in relation to the cost of its liabilities, leading it to make operating losses. Since Fannie Mae is thinly capitalized, such losses could easily lead it to insolvency. At that point, the nightmare of the 1989-90 S&L bailout recurs; public money has to be pumped in to bail out bankrupt housing finance institutions, and the Federal budget deficit soars to levels even above those of the early 90's.
There is a further distortion. By its monetary easing, and the consequent strength in consumer spending, the Fed has avoided the usual recessionary effect of an improvement in the U.S. payments deficit, which in 2000-2001 ran at $400 billion per annum, and now is $500 billion per annum, 5 percent of GDP. There is a point at which foreigners refuse to provide $500 billion of new money every year to finance U.S. consumers. At that point, there will be a collapse in the value of the dollar, a crisis of confidence in the Treasury bond market, a sharp rise in long-term interest rates and resurgence in inflation due to higher import costs. One modest benefit: if this happens soon, it will stop Fannie Mae going bust (unless of course the collapse in the housing market which will inevitably follow causes it to lose huge amounts of money through mortgage defaults.)
A stock market decline to around 5,000 on the Dow Jones index is inevitable, and has been inevitable since 2000. Such a decline must cause a painful recession, if nothing worse. By embarking in January 2001 on its policy of loose money and low interest rates, the Fed has delayed the fall in the Dow, and the recession, but at a cost of introducing further severe distortions into the U.S. economy.
It is likely that this tradeoff will prove in the long run to have been very unattractive.
