Why the Fed's Rate Cut Was a Mistake

The Federal Reserve cut the Federal Funds rate by 50 basis points on Tuesday. I think this was a big mistake and below I will explain why.

First, a big mea culpa. I have defended Bernanke over the last few months. My read of his actions was one of a prudent Fed Chairman calmly working through the problems he inherited. Right now I'm not sure what I think about his overall character. However, the size of the Tuesday's cut and the complete reversal of the Fed's tough on inflation stance in a mere month's period caught me very much off-guard. I detail the exact situation more here, but the short version is this: a month and a half ago, the Fed was confident the economy would come out of this mess fairly well. Suddenly, the Fed had an "Oh my God" moment and cut rates. The problem with this action (which I detail below) is it has the potential to create more problems than it solves.

First, a rate cut won't help the housing market. Here's why:

Remember that the 10-year Treasury and mortgage rates are closely tied to one another. Mortgage traders use the 10-year Treasury as a hedging tool in their portfolio. So, the value or yield of the 10-year is very important in the mortgage market.

Notice the 10-year yield has been dropping for the better part of the last few months. The reason is simple. The Fed continually said they were more concerned with fighting inflation and bond traders believed them (see this post for a complete rundown of all FOMC statements since January).

Yesterday the Fed basically said, "while inflation is still of a concern, we're now more concerned about economic growth." By lowering rates, the Fed was making the economy more vulnerable to inflation. This eats away at fixed income streams, so traders sell the 10-year Treasury. Because a bond's price and yield are inversely related, yields now move up -- which starts to increase mortgage rates.

As this weekly chart of the 10 year Treasury shows, yields are at a technically important point. Yields have been coming down (so prices are have been moving up). At this point, traders are simply looking for a reason to sell -- the Fed gave them one. The US economy is now more vulnerable to inflation thanks to yesterday's rate cut.

Treasury 10-year notes fell for a third day as investors speculated inflation will accelerate after the Federal Reserve cut interest rates by a more than expected half-percentage point.

The difference between two- and 10-year Treasury yields rose to 54 basis points, the widest spread in four weeks. The central bank reduced the target rate for overnight lending between banks to 4.75 percent yesterday, saying in its statement that policy makers are trying to contain the housing slump while continuing to monitor inflation risks.

``Long-term inflation expectations are going up and have been going up for the past couple of months,'' said Amitabh Arora, head of U.S. interest-rate strategy in New York at Lehman Brothers Holdings Inc., one of the 21 primary securities dealers that deal directly with the Fed. ``That is a concern for the Fed because it undermines Fed policy.''

Secondly, inflation is not dead. In fact, commodity based inflation is increasing.

Here are some of the unreported details from today's CPI report are not good:

During the first eight months of 2007, the CPI-U rose at a 3.7 percent seasonally adjusted annual rate (SAAR). This compares with an increase of 2.5 percent for all of 2006.

Of course, this is only if you're counting such unnecessary items as food and energy.

The larger advance thus far this year was due to larger increases in the energy and food indexes. Despite registering declines in each of the last three months, the index for energy increased at a 12.7 percent SAAR through August.> Petroleum-based energy led the acceleration with a 22.7 percent increase at an annual rate. Last year the overall energy index rose 2.9 percent. The food index also increased much more so far this year compared with last year, a 5.6 percent SAAR compared with a 2.1 percent rise for all of 2006. Excluding food and energy, the CPI-U advanced at a 2.3 percent SAAR in the first eight months, following a 2.6 percent rise for all of 2006

The gold ETF confirms the increase of the fear of inflation. Traders bid up this sector big time after the rate cut.

Oil is hitting new highs.

And agricultural prices have been increasing for the last two years.

The bottom line is the Fed was entirely correct in worrying about inflation. With lower interest rates, the possibility of higher inflation is now increasing.

Third, the rate cut weakens an already weakened dollar.

Let's backtrack through the latest expansion. One of its primary financial movers was the "carry trade". This is a fancy way of saying "I'll borrow money where interest rates are low and lend money where interest rates are high". One of the primary currency pairs in this was the Yen and the Dollar -- traders and lenders would borrow in Yen where interest rates were pretty much 0% after adjusting for inflation and lending in the US. They would capture the difference in the interest rates called a spread. Yesterday the Federal Reserve shaved 50 basis points (half a percent) off of that trade. That will effectively drive people out of the yen/dollar pair, forcing the dollar lower and the yen higher.

Here's a chart of the dollar from Stockcharts. Notice the big drop yesterday when the Fed lowered rates:

And here's a weekly chart. Notice the pronounced downtrend.

And I'm not the only one who is saying this is dollar negative

Fourth, and most importantly, the big problem right now is confidence in the credit markets. Let me back up and explain. In late July Bear Stearns announced that two hedge funds previously valued at about $6 billion dollars were essentially worthless. Other funds followed suit. These announcements froze the credit markets -- even the short-term commercial paper markets (paper due in roughly less than a year). Lenders were concerned that borrowers would would not be able to repay even a very short-term loan because of mortgage related assets on the borrower's books. Essentially, lenders were concerned they were lending to the next Bear Stearns fund.

While the Fed can attempt to provide liquidity, the Fed cannot dictate where that liquidity goes, if indeed it goes anywhere at all.

Yesterday's cut does nothing to change that problem. There is still a ton of bad debt out there on the books of a bunch of financial institutions. There are still going to be problems in the credit markets because a ton of garbage is still out there. Lenders are still going to be concerned that a borrower's balance sheet is going to blow up. Nothing has changed. Just because a borrower can borrow at a lower rate does not mean a lender will make the loan.

There were signs over the last few weeks that some of the problems were being worked out. But finishing the job would have required time and patience -- patience the Fed didn't have.

The best summation I have seen comes from the blog 24/7 Wall Street:

Bernanke and his associates may have helped the stock market for a few days. But, they may have hurt the economy more than they know. Weathering tough times in mortgages, sour buy-out loans and hedge fund woes are one set of things. And, those are probably manageable.