Slashed Interest Rates

Since August the FOMC (Federal Open Market Committee) has lowered short term interest rates 6 times, from 5.25% to 2.25% in March. Is this good for everyone?

Smart Money magazine (May '08) has an article by Roger Lowenstein about this topic. He says the thought that lower short-term rates are better is simplistic and arguably wrong. "Many people facing resets on adjustable-rate mortgages will see less severe rate hikes. But for society lower rates are not an unmitigated blessing. People with money in the bank or investments in Treasury bills and other short-term securities will see their income reduced. Retirees and others on fixed incomes, such as pensions, will lose out."

He continues: "When Americans are discouraged from saving, they have only two alternatives. The first is to start spending. This is why lower rates lead to higher prices." I had to stop and think this through. I believe his point is supply and demand. More demand, prices can stay high or increase.

Continuing: "You can think of each rate cut as sending a palpable signal to every American: Live better! Spend more! Buy the extra sofa! More videogames! So what if you max out your credit cards and your home equity line as well? "

The other alternatives is: "people convert their dollars to another currency." The rate cuts signal that dollars are poor investments; try euros or yen instead. This is why the dollar has plunged to an all time low. Commodity producers are boosting prices to compensate for what they perceive to be shrinking dollar value. Gold is up, coal is up, wheat is up.

Mr. Lowenstein: "Will this translate to higher consumer prices? It already has. Inflation over the past 12 months has been clocked at a rather alarming 4.3 percent."

He concludes that cutting rates is not a clear problem solver. "But if carried to excess, the Fed's interest-rate medicine could inspire the fear of inflation and delay the onset of recovery. When investors fear inflation, they are reluctant to lend long term, driving bond rates higher. This is why long-term interest rates, including those on fixed mortgages, have stayed fast despite the Fed's best efforts to lower them. A bear market in bonds is a real possibility."

The economy is a complex animal. No one pill is the cure.

'til later