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.
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 Daily Politics on BBC2 at 12:00 today.
source-Money Morning