Personal Finance Blog by Debit versus Credit

Why Another Rate Cut Could Do More Harm Than Good

November 17, 2008 | Filed in: Economy | 1 comment

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It’s clear that the root cause of the financial difficulties that we’re facing in the United States is not related to credit being too expensive. It’s quite the opposite in fact - credit is cheap right now but many banks are actually cutting back on lending. So what gives? Why are we sliding into a recession when the Fed has done just about everything that they could to avoid the “r” word?

To be honest with you I don’t truthfully understand everything that’s gone wrong to put our nation and the world in the situation that it’s in. It’s been a long and a drawn out process that some say has been 25 years in the making. Therefore it’d be near impossible for me to cover such a heavy topic on a blog.

Another Rate Cut May Be Near

Something did catch my eye while I was skimming the financial headlines that’s basically directly related to this current crisis and I want to talk about what I read and what I think about it. The Federal Reserve of the United States recently alluded to the fact that they may be making another rate cut in December.

What?

Didn’t we already establish that credit is not expensive? If you remember the last time the Fed cut rates to where they are at now I complained about the rate cut. I was a little annoyed, but to be honest now I’m upset. I think the central bank has forgotten some important details about the current crisis. They’ve forgotten that the American consumer has a great deal of influence in the state of the economy.

Let’s talk about this. I want to hear your opinions and I want your feedback, but more importantly I want to tell you why I think that another rate cut would be foolishness of foolishness.

Why Another Rate Cut Won’t Do Any Good

Another rate cut truly won’t have any affect on how willing financial instituations are going to be to lend money to one another. They aren’t likely to lower consumer loan rates. They will however have a near-immediate impact on consumer savings rates. You think your savings and cd rates suck now? Another rate cut will drop those even more.

It seems to me that these cuts are being made on a purely psychological basis. Almost as if they’re saying that they’re willing to do anything to get the economy back on track. That’s great and all, but is this really going to excite the average consumer? Are they going to see another rate cut and sigh a sigh of relief thinking that their money is going to be safe and we won’t go into a deep, dark recession? Not likely.

Uncertainty Leads to a Recession

The cause of just about any recession goes far beyond actual slowdowns in lending and consumer purchasing. It’s almost always intensified by uncertainty.

People are afraid right now. Truly afraid. If that’s the case then does it seem best to drop rates? I’m actually of the opinion that leaving rates the same could be more beneficial than a rate cut.

The news reports rate cuts nowadays as if they are some sort of super relief element used by the Fed to stop a recession dead in its tracks. Therefore the consumer thinks that a recession is a likely scenario. They stop spending and they start worrying. Suddenly we’re facing a recession. Why? Self fulfilling prophecy.

My Hypothesis on the New Psychology of Rate Cuts

I’m proposing then that a rate cut is more devastating (psychologically) to the average consumer in times of financial crisis than it would be to leave rates the same. By cutting rates the Fed is signaling that they’re afraid and they don’t know what’s going to happen. Let’s leave rates alone for once and see what happens.

You never know.

Tags: Economy, Federal Reserve, Rate Cut, recession, saving

Fed Cuts Rates to 1%

October 30, 2008 | Filed in: Economy | 3 comments

Many of you may have heard by now that the Federal Reserve cut their key fed-funds rate to 1%, bringing it in line with the lowest level that it’s ever been at. Interestingly enough the last time that the rate was at 1% was within this decade - from June of 2003 until June of 2004. Even more interesting is that many people and economists have laid partial blame for the housing crisis on this low rate, essentially saying that the fed made money too cheap and caused people to be greedy and take unnecessary risks. If all of this is the case, then what of this time? Will having such a low rate now cause unexpected hardships in the near future? Besides that what does it mean for me and you now that the fed funds rate is at 1%?

Let’s look at the facts…

First of all a description of what the fed funds rate is, from CNN Money.

The fed funds rate is used to set rates for a wide variety of consumer loans, including home equity lines and credit cards, as well as for many business loans.

You’ve likely heard of the prime rate.  The prime rate changes in line with the fed funds rate.  It is almost always 3% higher than the fed funds rate, which would put the prime rate at 4% sometime in the near future.  Almost all of the banking products that you use are based on the prime rate.  Both deposit accounts and loans change along with a change in the fed funds rate (and therefore the prime rate).  You can expect savings rates of all flavors (cd’s, money markets, savings) to drop and on the flipside you’ll likely see some loan rates to drop as well.

Keeping all of that in mind let’s take a look at what the lower fed funds rate is likely to do for the economy.  There are two options.  It will do nothing, as in not help at all, or it will hurt the economy.  There is no other option.  It most definitely will not help matters at all.  Why?

The problem with the current credit crisis is not that loans are expensive.  They’re actually pretty inexpensive.  At the credit union I work at an auto loan starts at about 5.5% and if you look at bankrate.com the national average for an auto loan is about 6.5%.  No, loans are not expensive, banks are just unwilling to lend, especially to each other.  They are afraid that if they lend out too much of their cash that they could end up in an illiquid situation and go bankrupt just like Lehman Brothers, WaMu or any of the other failures we’ve had as a result of this crisis.

One economist said it best, as quoted again from CNN Money.

“The latest Fed move is not going to hasten the economic recovery by a single day or accelerate the cleansing of bank balance sheets,” said Bernard Baumohl, executive director of The Economic Outlook Group. “What is needed more than anything else at this stage is simply patience.”

Be Patient Mr. Bernanke, Be Patient World.

This thing is not going to fix overnight.  There is no easy fix.  The fed funds rate at 1% won’t do a single thing to fix it.  So why lower it?  It’s probably purely psychological, and at this point it shouldn’t do much harm but I’m afraid the problem is that they won’t raise rates until the crisis cleans out completely, at which point it may be too late.  By then there may have begun another lending bubble.  Let’s hope Bernanke is smart enough not to let it come to that.

In the meantime let’s all practice a little patience, shall we?  It is after all a virtue, and shouldn’t we all strive to be virtuous?  If we were you can bet we wouldn’t be in the mess we’re in right now.

Tags: Credit Crisis, Federal Funds Rate, Federal Reserve, Prime Rate

When Will The Bailouts End?

September 18, 2008 | Filed in: Miscellaneous | 3 comments

Maybe it’s just me, but these bailouts seem to be happening more and more frequently these days. Six months ago it was Bear Stearns. Just two weeks ago we bailed out Fannie Mae and Freddie Mac. Now, as you’ve undoubtedly heard, the U.S. government has taken it upon itself to bail out American International Group, otherwise known as AIG. What was their reasoning this time around? What does this mean to us as taxpayers? Will the bailouts ever end? These are all questions that you have probably found yourself asking. I’d like to attempt to answer them for you.

Why Did We Bailout An Insurance Company?

To be fair AIG is involved in more than just insurance.  That is, however, their primary business.  Unfortunately they have had large levels of exposure to the credit crisis through an insurance-like product that protects the purchasers of the product from bond defaults.  Essentially they insured investments.  As so many of these investments are going south so is the cash of AIG as they are forced to pay out to their customers.  The problem lies therefore with their current level of capital.  They were unable to raise enough in time and their credit ratings were dropped.  This may have forced them to declare bankruptcy because they did not have enough cash coming in.  The fed stopped this though by offering an $85 billion dollar loan and agreed to taking an 80% stake in the company.  Essentially they just bought AIG.

Will This Affect Our Taxes?

More than likely this will not have an impact on our taxes.  But it may.  There’s something that a lot of American’s don’t know about the Fed and our government.  They have been running a budget deficit for a LONG time.  That much is common knowledge.  But think about it.  Where did they get the $85 billion to loan to AIG?  It wasn’t sitting in a vault somewhere twiddling its thumbs.  That much is for sure.  No.  When the government needs money they print it.  Just out of thin air.  They fire up the money machine and call it cash.  Of course if I tried to do this I’d be arrested for counterfeiting.  They ought to be arrested for causing high inflation.

So rest assured this money did not come from our taxes.  It may not either.  If AIG can pull through this ok the Fed hopes to sell their portion of the company back to the general public, at a gain.  But that doesn’t help the damage that’s already been done.  The fact is that the Fed and the treasury have thrown billions upon billions of dollars into the economy.  Dollars that didn’t exist before.  Is it any wonder why gas costs so much?  It shouldn’t be.

When Will The Bailouts End?

I’ll be perfectly honest with you.  I was surprised when the Fed let Lehman file bankruptcy.  I was pleasantly surprised in fact.  Don’t get me wrong.  I feel terrible that such a large business with so many employees was allowed to fail.  But it has to happen.  We are supposed to have a free market system.  There will be ups and there will be downs.  Right now we’re facing some serious crisis’ on wall street and in the financial system as a whole.  Things will eventually get better, but in the meantime there will be pain and there will be losses.

Right now WaMu looks like it may be the next target for failure.  They’re currently shopping themselves around for a buyer.  Their problem is also a lack of capital.  Cash truly is king.  Like I’ve been telling all of you, make sure you have an emergency fund for when a crisis comes into your personal life.

On that note I don’t think we’ve seen the last of the bailouts.  The Fed and the Treasury department have been too forgiving and too quick to pull the trigger.  These companies more or less deserved what was coming to them.  I hope that these bailouts will not create an attitude of “we can’t fail” in companies.  I hope that our country will be stronger after this crisis.  Unfortunately it’s looking to be quite the opposite.

What are your thoughts?

Tags: AIG, Bailout Nation, Bear Stearns, Debt, Economy, Fannie Mae, Federal Reserve, Freddie Mac, Rants

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