Rate cuts: why the Fed is just making everything worse

published 31 January 2008

This feature is part of our FREE daily Money Morning email. If you'd like to sign up, please click here: Sign up for Money Morning

There were no surprises from the Federal Reserve last night.

The US central bank cut interest rates by half a point, giving the market just what it wanted. And because the market was expecting it, it didn't really have much of an impact US stocks ended lower on the day.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

So now the US has cut rates by 1.25% in less than a fortnight. Interest rates, at 3%, are now well below the headline consumer price index inflation rate of 4.1%.

The Fed is simply giving money away. You'd be daft not to get rid of your cash when real interest rates are sitting at -1.1%.

Trouble is, that assumes you have any cash to get rid of in the first place

Here's the problem with the Fed's approach. It's now time for people and companies banks, specifically - to rebuild their balance sheets. So by slashing interest rates and devaluing money, you actually make it harder for them to do that.

People like to feel secure about their finances. That may sound strange given the credit boom we've just been through, when people have apparently thrown caution to the wind. But they weren't sacrificing security at least, not in their heads. Rather, they swapped the safety of a savings account for the safety of a house.

Why you can go wrong with bricks and mortar

After all, the past decade apparently proved that "you can't go wrong with bricks and mortar." And so dependent is the economy on housing, that "the government would never let house prices fall". They may sound like silly ideas now at least in the US - but you can still hear them being bandied about on internet bulletin boards throughout the UK.

But that property safety blanket has been swept away for US homeowners (and soon will be for their British counterparts approvals for new mortgages in December fell below the lowest point hit in the short-lived 2004/05 downturn, so hopes for a second-half rebound are looking ever more ridiculous by the day). So those who aren't in actual imminent danger of having their home repossessed will be looking to rebuild a secure safety net elsewhere. For most people, cash will be the main component of that safety net. But how can you hope to rebuild your financial cushion if it's being eaten away by inflation?

So in that context, low rates actually hammer people's confidence because there's no way for them to rapidly build up a decent cushion between themselves and disaster. And if people don't feel safe, then they don't feel like spending.

So what should the Fed be doing? Well, it shouldn't be destroying the monetary base, undermining confidence in the economy and the US in general even further. It doesn't matter how hard it or the government pushes people to spend, they don't want to anymore, and the banks aren't willing to extend endless lines of credit any more either.

Sure, have a big tax rebate but it's only going to go on paying down debt on a depreciating asset, which won't prop up your consumer economy. Have interest rate cuts but they can't fall far enough to allow sub-prime borrowers to refinance to avoid repossession, because no matter how far they fall, no one's going to lend to them anyway.

There's only one solution: spend less

So like it or not, there's going to be there needs to be a spending slowdown. And that will undeniably be painful for the US. If the government should be doing anything at all, then it's preparing for the fall-out from that downturn higher unemployment, more and more people losing their homes, and all the other nasty things that a proper recession brings with it.

Of course, the best time to prepare for the downturn is during the upturn, something that both the US and the UK have pointedly failed to do. That'll make the coming recessions more painful than they needed to be. But the point is that slashing interest rates now in the hope of a bail-out materialising, as it used to do in the past, will do more harm than good.

By the way, if you happen to be near a TV at lunchtime, and want to see our editor Merryn Somerset Webb giving her views on the week's events so far, tune into The Daily Politics on BBC2 at 12:00 today.

Turning to the wider markets

Enjoying this article? Why not sign up to receive Money Morning FREE every weekday? Just click here: FREE daily Money Morning email

US stocks give up post-rate cut rally

In London, the FTSE 100 had a lacklustre day - ending the day 47 points lower, at 5,837 - as investors exercised caution ahead of the US Federal reerve's decision on interest rates. Mortgage bank Alliance & Leicester fell, along with housebuilders Persimmon, Taylor Wimpey and Barratt Developments, after the Bank of England announced that mortgage approvals had fallen to record lows in December. For a full market report, see: London market close.

On the Continent, the Paris CAC-40 fell 67 points to end the day at 4,873. And in Frankfurt, the DAX-30 was 17 points higher, at 6,875.

Across the Atlantic, the Dow Jones rallied nearly 200 points after the Fed slashed the base rate by a further half a percent. However, early gains dissipated, with fears of downgrades for bond insurers Ambac Financial and MBIA adding to negative sentiment. The Dow closed down 37 points overall, at 12,442. The tech-laden Nasdaq was 9 points lower at 2,349. And the S&P 500 was 6 points lower, at 1,355.

In Asia, the Japanese Nikkei rose 247 points to 13,592. And in Hong Kong, the Hang Seng was down 197 points, at 23,455.

Royal Dutch Shell profits rise 60%

Crude oil futures were down nearly 1% this morning, at $91.49. Brent spot was trading at $92.04 in London.

Spot gold was trading at $923.80 this morning, still within reach of Tuesday's all-time high of $933.10. Silver had fallen to $16.74 from $16.82 in New York late yesterday.

Having risen to nearly $2 on the Fed's decision yesterday, sterling had fallen back to 1.9862 this morning as investors banked gains. Sterling was trading at 1.3383 against the euro, whilst the dollar was at 0.6736 against the euro. And the dollar was at 106.44 against the Yen.

And in London this morning, Royal Dutch Shell - Europe's biggest oil producer - announced that Q4 net income had risen 60% to $8.47bn, thanks to record oil prices. However, production fell for the fifth consecutive year and refining margins were also lower.

Our recommended articles for today...

This could be the death of banking as we know it

- Banks may have to abandon market intermediation and keep assets on their balance sheets again. It sounds bland enough - but these changes will have huge implications - not least the shift of financial influence Eastwards. To find out why Yves Smith describes the prediction as 'tantamount to saying that a comet has wiped out most the mammals and the dinosaurs will rise again', see: This could be the death of banking as we know it

Markets: prepare for more tantrums and sleepless nights

- Like an overtired child, there's no way the markets can calm down with everything that's been going on recently, says Merryn Somerset Webb. For more on why only the very brave would dare to take on this troublesome toddler right now, read: Markets: prepare for more tantrums and sleepless nights

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.