Never A Dull Moment

The Fed has flexed some serious muscle in the last week and a half, and I am feeling very positive about the outcome thus far.  Here’s the play-by-play:

Bear Stearns suffered a liquidity emergency (kinda like what would happen if everyone in New York flushed at the time to water, only with money),  ignited by some Wall Street whispering about looming balance-sheet problems.  Everyone tried to get their money out, and Bear simply didn’t have the cash or collateral to cover it.  So, JP Morgan Chase agreed to acquire the whole company at pennies on the dollar in order to keep it from going under.

In light of that, the Federal Reserve decided to open its lending window up to investment banks.  This is a huge move because investment banks live by a different, more dangerous set of rules than tradi­tional commercial banks.  Thus far, the move has provided a solid support under our sagging financial sector.

On Tuesday, March 18th, the Fed Funds Rate and Discount Rate were both cut by a whopping 3/4 point, bringing them down to 2.25 and 2.5 respectively.  This is on the heels of an emergency Discount Rate cut the Friday before by 1/4 point.  The Fed is getting really aggressive about injecting more money into the economy, and investors (and mortgage rates) are getting very skittish about the poten­tial for rising inflation.  Ben Bernanke included a no-nonsense speech about the fear of inflation when the rate cuts were announced.  There were even two dissenting Fed governor votes (1st time that’s happened in over a decade) hoping for smaller rate cuts.

To save us both some time, it suffices to know that inflation is the #1 arch enemy of fixed-income in­struments like mortgages.  If inflation shoots up, mortgage rates will follow suit, and that’s no fun for anyone.

So, despite popular belief, mortgage rates (aside from those tied to the Prime Rate) went UP when the Fed cut rates DOWN.  This quirky little shift is because low federal lending rates means a lot of money will be floating around which allows room for businesses to start jacking up prices.  Mortgage lenders are very afraid of that.

But, in my humble but accurate opinion, inflation isn’t going to get out of hand.  And here’s why.

Consumer wealth is hurting.  Bad.  Stock portfolios are shrinking.  Home prices are dropping.  The job market is tightening.  Wages aren’t going up as quickly as normal.  People are getting worried and saving more money than usual, keeping that cash out of business circulation.  Lending standards are tougher.

So, if John Q Public can’t borrow much money, is kinda worried about losing his job and sees his home equity back-sliding, it’s safe to say he’s not on the market for a new jet-ski.  And that takes money out of the jet-ski dealer’s pocket.  So he doesn’t take his wife out to dinner that night, and the server goes without a tip.  You get where this is going.  If businesses are seeing less volume moving, they will lower prices to lure in customers.  Hence, no inflation.

Also, the Fed is selling securities at a pace able to match the money being injected through lower rates.  This move essentially zero-balances the long-term financial impact and mitigates the potential for in­flation to flare up.

Lastly, even a little bit of inflation is self-cannibalistic in a slowing economy.  If prices go up, consum­ers will either trade down (like buying Publix brand instead of Kraft) or not buy at all.  So, we may see prices get a little bump from oil and commodity prices going up, but nothing noteworthy in the later part of this year.

But if rates stay too low for too long, we’ll start another bubble/burst cycle.  The Fed will most likely reverse course and raise rates once the markets stabilize.  Get ready for it.

I’m feeling positive, guys and gals.  And it feels good.  Mortgage rates are near three-year lows and there’s a lot of potential for them to go even lower.  House values are suffering, but that’s ultimately necessary to re-balance supply and demand and get the housing market moving again.

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