How Low Can We Go....the Dangerous Game of Interest Rate Cuts

Everywhere one turns, it seems that we are moving towards the general consensus in the US where recessions are to be avoided at all costs. When it comes to interest rate policy, "independently" determined by the Federal Reserve Board of Governors, somehow the main discourse seems to be not "if "we continue to cut rates, but by "how much and how quickly." At this point though, were getting quite close to the very low long term rates from 2001-2004 that many convincingly attribute as a primary cause of the mess we are in. From John Cassidy at Conde Naste;

"After adjusting for inflation, the cost of cash was close to zero. Investment banks, hedge funds, and other financial operators were able to obtain money at minimal cost and use it to finance risky investments. To a lesser extent, so could ordinary Americans. In a feat of levitation almost without precedent, the prices of nearly all speculative assets moved in the same direction: U.S. stocks went up; foreign stocks went up; residential real estate went up; commercial real estate went up; oil went up; gold went up; sugar went up; coffee went up; Treasury bonds went up; junk bonds went up. To make money, all you had to do was suit up, buy something, and sit back and watch it grow. In the real estate market, lenders competed frantically to make loans, and speculators flipped condos like burgers. With so much cheap money sloshing around, lenders had to work hard to find enough borrowers to mop it all up."

Some make the distinction, as Cassidy does, that it wasn't the low rates themselves that caused the problem, but the amount of time that the rates were left so low, especially given that an economic recovery had already begun to take hold. Again from Cassidy's interesting article;

"By the middle of 2002, however, it was clear that for whatever reason—low interest rates, the Bush tax cuts, increased military spending—the economy was staging an amazingly robust recovery. At that point, history and economic orthodoxy suggested that the Fed should have been tightening policy rather than loosening it.Again, Greenspan went his own way. Citing fears (which proved to be misplaced) of Japanese-style deflation spreading to the United States, he kept the federal funds rate at 1 percent until June 2004, by which point the economy had been growing steadily for more than two years. By failing to tighten monetary policy, Greenspan created an apparently limitless supply of cheap credit."

So, why not go back down to 1% or so, but this time we'll be smart enough to "take away the punch bowl" a lot earlier. Sounds logical actually, as its pretty hard to deny that things are a bit bumpy. One, more then just incidental problem though with the race to the bottom on interest rates line of thinking, is the dramatic and shocking increase, and even recent accelation that we are experiencing in the costs of commodities and the related fall in the US dollar. If, as in the tech bubble, Webvans or Microstrategy bubbles and goes bust, sure some people can get hurt, but the world goes on just fine. In our current situation, if the housing bubble after effects can cause this much pain, imagine how a widespread commodities bubble and a collapse of the US Dollar could ultimately effect us. At some point, the downside of rate cuts (I know, this coming weeks is pretty much "in the books") far exceeds the upside. A dollar collapse and a commodity bubble ultimately effects everything we do.....everybody eats, all of our widgets and gadgets are made of stuff and for the most part need hydrocarbon based energy to be made and / or work etc. Oh, and most of us at least here in the US have to use dollars to pay for stuff.

Surely, when it comes to outlier events such as the credit crisis we are now in, one can't just sit by and do nothing, can they? Of course not, and the Fed has already dramatically cut rates, which tend to work at a lag of up to 6 months or so, (from 5.25% to 3% now, and down to 2-2.5% by next week), as well as instituting a multitude of other actions (TAF, special term repo operations and increased TAF, TSLF, Bear Stearns temporary (hopefully) lifeline / bailout) meant to ease the crisis, as well. Are these going to "work"? If "work" means avoiding recession at all costs, perhaps not. If "works" means an orderly unwinding of the leverage bubble, and a more healthy longer term allocation of resources within our economy, then hopefully, these, and other non-rate cut steps can or will (of course the jury is still out and there is much to be debated as to the particular pros and con's involved in these steps). Before reaching for the easy elixir of rate cuts though, have a look at these long term 20-40 year monthly charts...

And last, but not least, going in the opposite direction unfortunately....