Fed Cuts Rates Again

On the back of news that GDP growth in the 4th Quarter of 2007 was a less than expected 0.6%, the Federal Open Market Committee (FOMC) cut rates for the second time in as many weeks this afternoon, lowering the benchmark federal funds rate to 3% and the discount rate to 3.5%. The Fed has now lowered rates 125 basis points over a two week period, the fastest drop in 17 years.

Many on Wall Street think that cheap money is the cure for our country's credit problems. However the tide is turning and cheap money is no longer the consensus solution. Many of the top economic thinkers and investors are starting to ask whether the "cheap money" era needs to come to an end. One prominent investor who is calling for an alternative approach is Bill Gross. He believes that it is time for a paradigm shift. He argues that U.S. and global demand has been driven for years by financially engineered lower interest rates and cheap credit. He believes our economy needs government help, and probably in the form of "a well constructed, more than temporary fiscal/monetary stimulus plan." I think Gross argues this point effectively, though I am always wary of government intervention: "because demand in the form of consumption has been artificially and fictitiously stimulated in recent years by financial engineering run amuck, there is a legitimate question as to whether its black hole imploding destructiveness can be totally countered with another dose of lower yields and deficit spending packages."

Mr. Gross' ultimate point:

My point is that Chairman Bernanke must recognize the reduced benefits and obvious dangers of a déjà vu trek to 1% short rates. Those yields produced 5% 30-year mortgage rates to the homeowner for a 2-3 month period in 2003 and they could do so again, but bubble creating, inflation inducing damage to the U.S. dollar would be the likely result now. Best to stop far short of 1% and at the same time encourage reforms in FHA government assisted programs that would permit subsidized mortgage rates with minimal down payments.

An artificially low, 1% short-term interest rate was an elixir during the days of a burgeoning shadow banking system. It cannot be the solution now.

Well it looks like Bernanke has failed to heed Gross' advice just yet and continues to use up a lot of his dry powder to prop up the weakening US economy. We'll have to wait and see how much lower he'll take rates before he realizes that another shot of liquidity won't help the economy much.

Note: In our quarterly newsletter sent out to clients I had predicted 3% short interest rates by the 4th quarter of 2008, but never thought we'd hit 3% in January!

Hat Tip: Bill Gross