Zaks Investment Advisory Service

The Federal Reserve, Rates, Inflation and the Housing Market

Our attention must turn to last week’s stock market and broader economic developments. On Wednesday, coming out of a two-day meeting, the Open Market Committee of the Federal Reserve decided to once again lower the federal fund rates, this time by 50 points. This would not have come as such a surprise had the Federal Reserve not convened an emergency meeting just eight days earlier, lowering the rates by 75 points. Thus, the rates have been cut by 125 points over an eight-day span. I do not remember the Federal Reserve ever lowering rates so quickly before. This is especially striking if one recalls that at its last regular meeting, just one-and-a-half months ago, the Federal Reserve lowered rates by only 25 points, even though many economists at the time believed that the Fed should be cutting the rates more aggressively. But at the time, the Federal Reserve felt that even though the economy was slowing, its state did not demand more decisive action. Looking back (which, as we know, is always easy to do), it appears that the Federal Reserve was wrong.

To a certain extent, amazingly, we have just one person to thank for such vigorous action by the Fed – a Frenchman by the name of Jérôme Kerviel. Everyone, of course, has now heard of this trader from Société Générale bank. At his own discretion and in breach of bank rules, he made huge bets on the futures market. He was speculating that the market will go up, but instead it continued to fall. When bank management learned that Kerviel had risked some $70 billion dollars, it urgently sold his position. This happened in the midst of a European market drop: our exchanges were closed in commemoration of Martin Luther King Day, but both the Asian and European exchanges were responding to our market’s fall the preceding Friday. At this critical moment, with the markets already under pressure, Société Générale was forced to sell futures on stocks with a nominal value worth tens of billions of dollars. This could not but affect the European markets, which fell that Monday by about seven percent. At the same time, our Federal Reserve decided to lower rates by 75 points. Officially, the Federal Reserve does not cut rates to help the stock market, but it was unlikely to have been a random coincidence in this particular case.

Be that as it may, the two urgent reductions in interest rates made an impact on the market: it has gained 5.3 percent over the past two weeks. Nevertheless, the market still stands lower than where it was one year ago.

What interests us, though, is what happens next. With the usual disclaimer - that none of us can really know this for sure, I could still make the following observations. The housing market crisis is weighing heavily on our economy. This market is enormous and any changes to it affect the economy as a whole. At the moment, real investments in housing are falling, i.e. fewer new houses are being built than usual. Our Gross Domestic Product suffers as a result. Moreover, housing prices are continuing to fall, and this has a negative effect on the entire financial system. Economists have calculated that on aggregate, the housing market crisis has reduced our GDP by 1.2 percent. Incidentally, at the same time, the rest of the economy is holding on pretty well.

The lower interest rates will help the American consumer: for example, credit card and car-purchase loan rates will both drop. This should help the housing market as well, although the situation here is somewhat more complicated. The fact is that mortgage rates depend on the long-term interest rates. And, as we discussed at one point, lower federal fund rates (i.e. short-term rates) do not necessarily affect the long-term rates much. Moreover, if the market decides that the rates reduction might spur inflation (and this is a very real eventuality), then the long-term rates could actually rise rather than fall! Thankfully, at the moment the market does not believe that inflation will grow. How do we know this? The federal government issues bonds called TIPS (Treasury Inflation-Protected Securities). They pay an interest that depends on the inflation level: the higher the inflation, the higher the payment, and the vice versa. TIPS thus protect the investor against inflation. The difference between the yield on an ordinary federal government bonds and TIPS of a similar maturity gives us an idea about where inflation might head. Even after the Federal Reserve lowered its rates, the market continues to predict that inflation will not grow in the near future. This is a good sign since it potentially allows the Federal Reserve to lower rates again to help stimulate the economy.

Unfortunately, low mortgage rates will not necessarily help all homeowners, especially not the ones who only recently purchased their homes. Theoretically, they could refinance their mortgages, thus reducing their monthly payments. In practice, however, if a homeowner paid off, say, five percent of the house’s value over the past few years while the price of their house in the meantime fell by 10 percent, the mortgage ends up costing more than the house itself. Many banks refuse to refinance rates in such cases. Nevertheless, on the whole, lower mortgage rates cannot but help the housing market, too.

We do not know what will happen to the economy as a whole. According to preliminary Labor Department data, the number of employed people fell in January. However, these figures are often adjusted: for example, updated data show that in December, the number of workers was significantly higher than initially reported. I hope that these interest rates cuts will help stave off recession and push markets higher by the end of the year. I, at the very least, am not changing my forecast of where the market will stand at the close of 2008.

And with this, we will draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.