THE BLOG
01/23/2008 08:36 am ET Updated Dec 06, 2017

Why the Fed's Rate Cut Was a Mistake

Yesterday, the Federal Reserve cut interest rates by 75 basis points, or .75 of a percentage point. There has been a lot of commentary about what this move means and what it signals. I fall into the camp of "this won't do a damn bit of good" and below I'll explain why. This is a compilation of posts from my blog yesterday.

Interest rates aren't that high right now.

To listen to the rate cutting crowd, you would think that interest rates were at godawful levels that prevented lending. Nothing could be further from the truth.

Above is a chart of the effective Fed funds rate. I eyeballed a line from current rates back through the history of previous rates. Notice today's rates aren't that high, especially in a historical context. In other words, money isn't that expensive right now.

Above is a chart of th constantly maturing 10-year Treasury. Note that rates have been declining for nearly 20 years.

Above is a chart of AAA corporate paper. Notice the highest rates have been during this expansion corresponds to the low point of the previous cycle. Simply eyeballing the chart, it looks like AAA corporate paper is about 5.25%. That's not expensive at all.

The same analysis goes for BBB paper -- it's just not that expensive to borrow right now, even for a riskier corporate credit.

So -- interest rates just aren't that high right now.

Inflation is on the horizon

You've seen them before and you'll see them again. I should probably start asking regular readers to draw these graphs from memory. But --

Agricultural prices are in the middle of a three year bull run

And oil prices are in the middle of a year long bull run -- although they may be forming a double top here. But either way -- oil prices have increased smartly over the last year.

So -- we may have a really ugly inflation picture emerging.

Let's look at what got us into this mess.

Look specifically at the rates from the early 2000s. I drew a line from those levels all the way back to the beginning of the chart. Notice that rates were not that low for about 40 years.

Let's look at what else happened during that time. Here is a chart of total household debt outstanding:

And here is a chart of the last 10 years of total household outstanding:

Notice the mammoth increase? Total household debt outstanding went form about $8 trillion to a little under $14 trillion, or an increase of about 75%.

All of that debt has to go somewhere -- it doesn't exist in a financial netherworld. It has to become an asset to somebody. And it has -- in the form of a massive amount of securitizations which are currently being written down by literally every financial name in the business. So far we've seen about $100 billion or writedowns in the financial markets and we are going to see more. That's the central problem right now; it's not interest rates but the amount of crap on the books of various financial players (hell -- all the financial players).

In other words, the problem isn't the need too underwrite more consumer debt -- we are already choking on consumer debt. The problem is the system made too many loans that are now going bad. And the only way to wean us off of that problem (easy money) is to feel the pain so we don't do it again.

Let's take a look at money supply. I'll be using MZM which is:

A measure of the liquid money supply within an economy. MZM represents all money in M2 less the time deposits, plus all money market funds.

Here is a chart from the St. Louis Federal Reserve of the total MZM money supply:

Notice that starting in late 2005 the total started increasing and has been increasing ever since. Let's see what the percentage change chart looks like:

This number has been increasing for the last year and a half, indicating money supply is increasing.

And then there is M3, which the government no longer publishes but which is available from the website shadowstats:

That's a huge increase.

So -- the issue isn't money supply. The facts show there is ample money in the system. The basic problem is no one wants to lend right now.

From the WSJ:

The glum news from U.S. banks continued with steep declines in fourth-quarter profit at five large lenders, led by Bank of America Corp. and Wachovia Corp., while mortgage-related woes plunged regional bank National City Corp. to a steep loss.

.....

The results capped a miserable earnings season for the banking industry, which was riding high until the mortgage meltdown triggered huge write-downs on investments, forced banks to begin hastily rebuilding loan-loss reserves, and exposed how far many lenders strayed from their roots during the housing boom. "It is back to basics," Bank of America Chief Financial Officer Joe Price told analysts in a conference call yesterday.

.....

Despite saving $500 million a year with the dividend cut, Jeff Kelly, National City's chief financial officer, said the Cleveland bank still is considering "a number of options for nondilutive...capital issuance this quarter."

.....

At Regions Financial Corp., Birmingham, Ala., which has a major presence in Florida and other parts of the Southeast being clobbered by the housing downturn, profit tumbled 80%. KeyCorp, of Cleveland, reported an 83% profit decline. Fifth Third Bancorp of Cincinnati saw its fourth-quarter net income slide 39%. National City swung to a loss of $333 million, or 53 cents a share, from a year-earlier profit of $842 million, or $1.36 a share.

While all six banks said the performance of many businesses remains at least decent overall despite the weakening economy, deteriorating credit quality is causing loan-loss reserves to balloon in anticipation of further trouble. The six banks reported a combined loan-loss provision of $6.22 billion in the fourth quarter, up 181% from $2.21 billion a year earlier.

The financial sector is really sick right now. And it's not just one player -- it's everybody in the system. Loan loss reserves are increasing, banks are looking at ways to increase capital, writedowns are hammering earnings.

The underlying hope of a rate cut is it will encourage financial players to make new loans and thereby stimulate the economy. But what banks are looking to repair the damage of previously made poor lending decisions, making new loans is far from their minds.

The facts are clear:

1.) Interest rates aren't high right now. In fact, they are downright inexpensive.

2.) Debt levels are high right now. More loans aren't the answer -- paying off some of that debt is.

3.) Money supply has been increasing at decent rates, indicating there is plenty of cash in the market.

4.) The financial sector is sick as a dog and has to heal itself. That's going to take time and prevent them from doing what the Fed wants them to do, which is make loans.

I will admit that I have a great deal of sympathy for Bernanke. Greenspan inflated the last asset he could (housing), waited until the market topped and then handed the keys of the economy over to Ben and said, "Good luck (you're really going to need it.)" Essentially, Ben is between a rock and a hard place with no good options available.

However, the main problem of the US economy is we are literally choking on debt right now -- and some of that debt is really bad debt meaning it won't get paid off. So the economy has to go through a period of de-leveraging -- getting rid of some of that debt. And that will take time and be painful. And frankly, there really isn't a way around it right now.