The Federal Reserve lowered its Federal funds rate target 25 basis points to 2 percent last week, while issuing a more even-handed policy statement that provides room for the central bank to pause and allow easing to impact the economy (smart move). The Fed acknowledged that economic growth is likely to remain weak over the next few quarters. The Fed Chairman remains worried about inflation, but he expects inflation to moderate with future monetary policy changes. Importantly, the FOMC altered key language in its policy paragraph, indicating that “further ease is no longer imminent.”
With the latest 25 bps ease, the FOMC has lowered the Federal funds rate by 325 bps since the financial crisis took shape last August. The Committee noted in its statement that there has been “substantial easing of monetary policy to date,” which, “combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and mitigate risks to economic activity.”
We believe higher inflation, a weaker dollar, and firmer economic growth will give Bernanke reason for pause. It is time for the FOMC to stop targeting interest rates as a sole cure to address weakness in financial market. The economy needs time to digest the benefit of 325 bps.
The recent backup in treasury yields seems to be signaling that investors’ anxiety has eased. The 10-year treasury yield is up 50 bps from its March low as investors move away from this traditional safe harbor. This suggests that the possibility of a more extensive credit-market meltdown has dwindled sharply. The economy is weak but getting stable. Last week’s gross domestic product report showed the economy grew 0.6 percent in the first quarter of 2008 (it didn’t decline as many feared). Despite all the troubles out there from housing to credit to oil, the economy has refused to roll over.
The Chicago PMI, a key gauge of the manufacturing sector, came in a bit higher than forecast, a possible sign that the worst may be over for that troubled industry. Also the government reported late last week that factory orders for March rose 1.4%, much higher than expected. Finally, the increase in personal spending for April was also a bit better than expected, showing that consumer confidence is turning the corner.
The unemployment rate dropped last month from 5.1 to 5.0% (excellent unexpected news), monthly jobless numbers and weekly initial jobless claims remain well below the sort of level technically seen during a recessionary period. And with all that monetary stimulus – plus tax rebate checks beginning to work their way through the economy, there is a good chance the economy will firm up without any further Fed action. And when the fear of recession is over and the possibility of growing inflation is still lingering, the Fed will start to move the interest rate higher. We might see that happen before year end.
The financial markets have stabilized in recent weeks as policymakers acted forcefully to contain downside risks. This has improved the economic outlook somewhat. The current downturn was particularly damaging to the investment and transaction side of Commercial Real Estate. The greatest weakness in this industry is not the lack of strong fundamentals in our economy, but the absence of lending practices that have crippled transaction activities.
The banks are very nervous and are trying to rebuild their battered balance sheet and are likely to remain skittish until reality overtakes their fear.
Lenders aren’t helping the central bank although they’ve been given eight interest rate cuts and a new program designed to jumpstart borrowing under new regulations. Banks’ failure to lower mortgage rates despite the significant cuts in the cost of money eventually will hurt the banks more than it will benefit them. Excessive tightening of lending and credit rules by the banks will create a significant void in their pipeline and will impact their profitability for many quarters to come. It is ironic to see lenders go from complete lack of lending discipline to nearly halting all lending in less than eight months. Hopefully they will learn something from this era?
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The banks response to this crisis reminds me of the passive parent who does nothing to create healthy boundaries for his teenager until the kid finally gets into trouble. Then the parent goes overboard with punishment and rules. Both methods are the bi-product of the same thing – bad parenting.