WeeklyBasis 10/29/07: Why The Fed Shouldn’t Cut Rates

This week opens strong with Jumbo and Conforming fixed and ARM loans all down .25%. Since Fed Chairman Ben Bernanke’s October 15 comments that the housing market may be a significant drag on economic growth, rate markets have been pricing in a .25% Fed Funds cut ahead this Wednesday’s FOMC meeting. At that time, I was still betting the Fed would hold. Looks like I may be incorrect, but I stand by my position that there is no compelling inflationary or recessionary data to push the Fed either way – at least not so soon after their recent cuts (-.5% on Fed Funds and -1% on Discount Rate).

THE FED’S BALANCING ACT
To be fair, if the Fed cut now instead of waiting until their December 11 meeting, it would show markets they’re ready to react to any further credit market and/or consumer weakness. But Fed cuts hurt an already weak dollar, which can push rates up in two ways. First, a weak dollar usually means Foreign buyers back off U.S. investments. When they dump stocks, it’s bad economic growth overall. When they dump bonds, it has a direct upward impact on rates (since bond yields, or rates, rise when bond prices drop). Second, a weak dollar raises prices for imports which is inflationary, and the Fed’s job is to hike rates if inflation becomes a problem.

So the Fed has to balance all of this, keeping benchmark rates where their neither over-stimulating the economy (and causing inflation) nor restricting money flows (and causing recession). It’s a tough balancing act because their decisions take time to affect the economy. It’s much like starting the shower when you’re in a hurry. You turn on the hot all the way to speed things up, and it’s way too hot when you step in. So you jolt the handle to cold, and it goes too far the other way. Market data, or market crises like we saw in August and September, can cause the Fed to adjust the controls too much in one direction.

WILL RATES RISE AGAIN IF FED CUTS?
After the Fed cut the Fed Funds Rate and Discount Rate on September 18, mortgage rates actually rose because bond (or rate) markets were overbought. It’s important for clients to understand that Home Equity Line of Credit (HELOC) 2nd mortgages are the only type of consumer mortgages that have a direct correlation to the Fed Funds Rate. All other mortgage rates are based on trading in bond markets, which reference Fed rates for influence, but are not directly correlated to moves in Fed rates.

If bond traders don’t like the Fed action or the Fed statement Wednesday, bonds could sell off. In addition to the Fed rate decision, we have GDP and consumer inflation reports Wednesday and Thursday, and the all-important monthly jobs/wage growth report on Friday. It’s going to be a wild ride, so please let me know if you have questions about reports are they’re released.

Conforming ($200,000 – $417,000) – NO POINTS
30 Year: 6.25% (6.39% APR)
5/1 ARM: 6.0% (6.14% APR)
7/1 ARM: 6.25% (6.4% APR)

Jumbo ($417,001 – $650,000) – NO POINTS
30 Year: 7.0% (7.14% APR)
5/1 ARM: 6.25% (6.39% APR)
7/1 ARM: 6.5% (6.65% APR)