MacroMaven Stephanie Pomboy, who weighed in on interest rates a few years back, quipped that the US economy can no longer handle higher interest rates in a way that echoes Jack Nicholson yelling at Tom Cruise in A Few Good Men that he can't handle the truth.
Jack Nicholerson (Colonel Jessup): You want answers?
Tom Cruise (Kaffee): I think I'm eligible.
Jack Nicholson (Colonel Jessup): You want answers?
Tom Cruise (Kaffee): I want the truth!
Jack Nicholerson (Colonel Jessup): You can't handle the truth!
“Son, we live in a world that has walls and those walls must be guarded by men with guns. who will do it? You?... I don't have the time or inclination to explain myself to a man who gets up and sleeps under the blanket of freedom I provide and then asks how I provide it. I'd rather you just say "thank you" and go on your way. Otherwise, I suggest you take your weapon and take your post.''
Colonel Jessup's responsibility to secure our basic freedoms is not unlike the Federal Reserve's mandate to create jobs and promote economic growth. And right now, that clearly requires the Fed to cut rates aggressively to keep the walls of economic growth from collapsing.
To contain or otherwise combat the rising walls of inflationary pressures in our economy, the Fed steadily raised short-term rates to 5.25% by mid-2006. However, the 50 basis point cut on September 17th was a loud and clear message from the Fed. Financial markets on September 17 with their 50 basis point rate cut is that we can't handle higher rates. So let the wall of inflationary pressure rage for now.
Bernanke's 50 basis point rate cut by the Fed suggests that the team of macroeconomic and quantitative analysts (MAQS) who have been diligently studying a range of scenarios for the US economy over the past few weeks may not have liked what they saw.
The Fed's Bernanke-led MAQS team was created to ensure that it does not engage in a series of excessive rate cuts during times of stress on the financial system. In retrospect, the Fed's Bernanke feels that Greenspan's third rate cut in 1998, as well as the aggressive easing of 2001-2003, were somewhat excessive and that "the Fed [actually] overpaid for risks that turned out to be less severe."
San Francisco President Janet Yellen noted that a good example of Fed overpayment in the past followed "the aftermath of the Russian debt default in 1998. Many forecasters had predicted a sharp economic slowdown as a result, but growth turned out to be strong." The third cut occurred in November 1998, when GDP growth in the 4th quarter of 1998 reached 6.2%.
The "what-if" scenarios worked on by the Fed's team of analysts, aka "Alt Sims," or alternative simulations, adjust for "such things as higher financing rates ... a sharp decline in home prices" or a sharp acceleration in mortgage foreclosures. glimpse possible future outcomes by leaving rates unchanged or relatively unchanged. The scenarios in a "relatively unchanged interest rate environment" had to be downright ugly.
In searching for the right amount of rate cuts that would be needed for this credit crunch, the Fed must have felt that 25 basis points would surely be too little. This also underscores the Fed's serious concerns about the US economy in a way that also reflects the Fed's sudden and serious concerns about the US economy that emerged in January 2001.
On January 3, 2001, the Fed surprised financial markets by cutting interbank rates by 50 basis points. They followed with further rate cuts of 50 basis points on January 31, 2001, then another 50 basis points on March 20, 2001, May 15, 2001, and September 17, 2001. They cut by 200 bps in five months and by 250 in the first nine months of 2001 bps.
This damned the US dollar forever. It took a while for the dollar to succumb to the Fed's aggressive rate cuts, but it eventually tripled from October 2000 to January 2002. Peak valuations of the dollar at that time were in the range of 119-122. Six years later and the dollar is now worth only a third of what it was at the start of the decade.
It is not known whether the Fed Funds rate will drop by 200 bps or more over the next three quarters. The sooner they start cutting only 25 bps at each FOMC meeting, the better.
There is an almost unshakable faith in the Fed's ability to weather financial turmoil with accommodative monetary policy. And stock markets do extremely well during these cycles of Fed monetary accommodation. This is why the saying on Wall Street is "Don't fight the Fed."
The only time in recent history that the stock markets did not do well during the Fed's adjustment cycle was 2001. That year the SP 500 fell 22% from the second 50 basis point rate cut on January 31, 2001 to March 22, 2001. I don't expect a similar result for stocks, because the economic background is completely different, we must still be aware that the Fed is not infallible. There is always the possibility that they have fallen behind in their response to the current financial crisis, but there is no sign of that so far .
Muhammad Umair
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