Fed 0% interest rates in the making

Excerpt from Kathy Lien

The Fed decided to yield to popular opinion Wednesday by cutting rates by 50bp. With an economic crisis that may continue into the foreseeable future, the Fed will have less and less ammunition as rate cuts begin to draw down to the zero figure.

The amount of slack left may be insufficient as it is because recent rate cuts have only been met with tightening credit conditions. It seems that newly created Fed initiatives, like making purchases in commercial paper and buying equity in banks, will have to be relied upon more as lower interest rates begin losing their effectiveness.

We continue to believe that the market will call upon the Fed to cut rates further, as economic conditions persistently weaken. In particular, recent complications in the auto industry may set up an accelerated series of layoffs, which could have a large negative effect on next week’s employment situation.

Notice how the Fed’s rate cuts have had little effect on mortgage rates and corporate bonds rates? Thus lending credence to my theory from last year (after the first rate cut) that the rate cuts would have little impact on the credit crunch since it was a function of loan losses, bad risk management, investors losing money, derivatives abuse, etc, as opposed to being a function of high interest rates.

Taking it a bit further: you can cut interest rates to zero and it won’t change the reality of overleveraged and undercapitalized banks that are facing escalating loan losses, or a nation full of borrowers that are either overleveraged (in general) and/or struggling with mortgages they can’t afford.

Not to mention the fact that it’s illogical to think that you can solve a problem that was partially caused by low interest rates with low interest rates.

Now suppose you could interpret this to mean that things would be markedly worse without the Fed’s rate cuts. You could also say that the Fed simply misinterpreted the impact of their rate cuts on the credit crunch; after all weren’t the rate cuts supposed to make mortgage rates fall, give relief to ARM borrowers, etc?

Either way the Federal Reserve and Wall St. have both become over dependent on rate cuts as a way to generate growth, and now with interest rates at 1.0% maybe both parties will begin to focus on the economy’s actual problems instead of hoping rate cuts will magically fix things.

US is a nation of analysts, pundits, politicians and policy makers who can’t seem to tell the difference between a root cause problem and a symptom.