Fed Rate Cuts… Why the First Fed Cut May Be the Last

by Alexander Green, Chairman, Investment U
Monday, September 24, 2007: Issue # 714

Last week I had dinner with Ajit Dayal, the former manager of the Vanguard International Value Fund (VTRIX).

During our conversation, he told me he hoped the Fed would leave the discount rate unchanged. “All those people who borrowed too aggressively, who loaned too leniently, and who invested too imprudently they need to be punished,” he said.

“If they don’t learn a lesson now,” he added, “it will only be worse the next time.

“I saw his point. But I disagreed with his view on Fed policy. I believe the Fed did exactly the right thing cutting the discount rate a half point.

But I think investors are sadly mistaken if they believe this is the beginning of a sustained period of easing. Believe it or not, the Fed rate cuts may be done or close to it.

I know virtually no one is saying this, but hear me out.

Keeping Economic Growth In the Black

It was only two months ago that the Fed believed that inflation was the biggest threat facing the economy, not recession. And for good reason…

Oil is over $80 a barrel. Energy, of course, is required for homes, offices, factories and transportation. The price of oil has more than quadrupled over the last eight years.

The dollar is weak, too. That boosts the cost of imports and allows U.S. producers to raise prices with relative impunity.

And money supply growth is off the charts. Lowering short-term rates only makes the problem worse. In other words, Bernanke’s cut actually worsens the inflationary pressures he’s supposed to be fighting.

Furthermore, the Fed Chairman made it clear in his Jackson Hole address last month that the Federal Reserve will not act to bail out banks with bad loans, homeowners with too much debt and investors with risky securities. Bully for him.

He knows that for capital markets to work efficiently, good risks have to be rewarded and poor risks have to be punished.

So why was cutting the discount rate a good move? Because the credit markets are still not functioning properly.

If you’re a business owner and you can’t meet your obligations because the people who owe you are not paying up, there is the possibility of a real financial panic with serious economic repercussions.

If a hedge fund manager can’t liquidate his sub-prime mortgage positions, that’s one thing. But when a business owner can’t meet payroll because the commercial paper market has seized up, that’s quite another.

The job of the Federal Reserve is to both maintain a stable currency and mitigate the severity of an economic slowdown.

True, the dollar has plunged in value in recent years – due in part to Mr. Greenspan’s policies – but it has been an orderly decline.

And while the housing slump may eventually send the economy into recession, we’re not there yet. And we may not get there. As bad as things are in the housing sector, it is responsible for only 8% of the nation’s jobs.

Homebuilder’s woes, weak residential resale prices, and the inability of consumers to borrow against their equity further, may eventually drive the economy into recession. (And if that appears to be happening, the Fed will continue to cut rates.) On the other hand, rising productivity, historically low interest rates, increased capital spending, and unprecedented demand from foreign markets (particularly China and India) may keep economic growth in the black. If that’s the case, Mr. Bernanke could be much closer to the end of his easing cycle than most investors think.

In short, last week’s cut was meant to bail out Main Street not Wall Street.

Investors would be wise not to confuse the two.

Good Investing,

Alex

Today’s Investment U Crib Sheet

Right now, 10-Year Treasuries yield a mere 4.62%. That’s hovering near 40-year lows and it’s well below their 8%-plus average over the last quarter century. Unless you’re already independently wealthy, investing in bonds alone won’t produce enough cash for a lucrative retirement. After all, Americans are living longer, and Social Security is a “demographic time bomb.”

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