U.S. Federal Reserve Decision on Interest Rate Cut on September 18th Will Have Little Long-Term Positive Effect on Stock Markets

September 15, 2007 –

Everybody is waiting now for this Tuesday’s decision by the Feds to finally learn how much the Feds slash interest rates. This decision is truly not that important for a number of reasons. (1) The Feds have already slashed interest rates in a couple of manners. One, by already injecting billions and billions of dollars into the banking system, they have already expanded monetary supply (which is the effect lower interest rates would have); and two, they have already slashed the discount rate (the rate at which banks can borrow from the government) again expanding money supply. True, the fed funds rate is what matters to the end consumer, but the actions the Feds already have taken will be harmful on the value of the U.S. dollar. It’s just a sneaky way of doing it without announcing to the world that they’ve slashed interest rates.

Thus, the news this Tuesday is likely to be less than overwhelming from the standpoint of the consumer that is looking for a substantial 50 to 75 basis point cut. Furthermore, the Fed has stated that inflation concerns are more worrisome than concerns of slowing U.S. economic growth. This is a curious statement as the Feds are primarily responsible for creating inflation through their easy money, monetary expansion policies. Their solution to any economic problem in the past has always to break out the printing presses and print as many dollars as is needed to provide a band-aid fix to the problem. And they probably will continue to sacrifice the dollar’s value for the sake of keeping up appearances in the future as well.

However, recent rallies in the U.S. markets last week have already factored in an interest rate cut as a given, so unless the news on Tuesday is overwhelmingly positive on the side of a cut, the news may sustain a brief rally in the stock markets but nothing that is fundamentally sustainable as interest rate cuts do not solve the irresponsible risk management policies of banks that have created this liquidity crunch. In fact, it does just the opposite. Instead of punishing banks for their greed-driven behavior, it rewards them, sending a message that every time your greedy behavior causes problems, the Feds are here to bail you out. Certainly if the Feds leave interest rates the same, or really shock people by raising them ( a possibility that hasn’t been discussed at all but is a lot more plausible than anyone thinks), then the markets will be thrown into turmoil again.

In the end, no matter what they do, the effects are likely to be negative on the markets short-term and long-term. We probably won’t see a 50 to 75 basis point cut so the good news of a 25 basis point cut has already been factored into the market’s run last week. No significant rally should happen due to a 25 basis point cut. Any policy of monetary expansion as a solution to poor risk management on behalf of financial institutions is a band aid solution to a bleeding aorta vein, and while it may boost consumer confidence short-term, it will only do so because consumers typically do not understand the dynamics between interest rates, monetary expansion, currency value, and global market behavior. Cut interest rates drastically, cut them moderately, leave them the same, or raise them — none of these decisions can solve the underlying problems of the market that lurk beneath the surface. And even if the Feds surprise the markets with a generous rate cut higher than expected, it may prop up markets for several months, but it will only do so by at the same time setting them up for a harder fall in the future.

[tags]politics and stocks, U.S. Federal Reserve, interest rate cut[/tags]

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