Deja Vu! The Fed Jumps Into Action Once Again
Posted on 02/27/2008, 13:36
By Dana Nicholas
After watching non U.S. markets decline sharply on fears of a U.S. recession, the Federal Reserve finally jumped into action in the final weeks of January. In an effort to calm the markets, short-term rates were unexpectedly slashed by 75 basis points before U.S. markets opened on Tuesday, January 22. Eight days later the Fed knocked another 50 basis points off the fed funds rate in their scheduled FOMC meeting, bringing rates down to 3%.
Although the markets responded favorably, the effects were short lived. After a two week rally, the Dow took its biggest hit in eleven months, tumbling 370 points to 12,265 as nervous traders faced renewed fears of an economic slowdown.
There is mounting evidence to support these fears. A report released by the Institute for Supply Management (ISM) shows that the service sector experienced an unexpected hit in January, contracting for the first time in 58 months.
This followed quickly on the heels of last week's Labor Department report, showing that employers axed 17,000 jobs in January - the first decline in four years.
Haven't We Been Here Before?
The recent actions of the Fed are reminiscent of 2001, when Greenspan began slashing interest rates to stave off recession and President Bush put forth a Stimulus Package designed to improve the economy.
Now, 7 years later we have reached a new crisis point. The Fed has once again started slashing rates, and another Stimulus Package is waiting to be passed.
The rate cuts and Stimulus Packages are both the direct result of speculative bubbles ... first the tech bubble that popped in March, 2001, and more recently the housing bubble. But there is a very big difference in the cause and effect of these bubbles.
In the late 1990's investors drove stock prices up to unrealistic highs, giving companies a low cost source of funds. They then used those funds to purchase the latest technology, secure larger office space, and add staff ... all of the things a company does when it expects to continue expanding.
But when the bubble burst in March of 2000, those firms had to cut back on new investments and staff. Thus, they took the steps necessary to bring their costs in line with the new reality.
It was painful. Investors lost money, workers lost jobs, and companies failed. But it all would have come to pass in time.
Instead, the Fed stepped in with rate cut after rate cut, leading the way to our current recession fears.
Cheap Cash Comes at a High Cost
Today's housing bubble is a direct result of the actions taken to ward off recession in 2001. Cheap and easy access to huge amounts of cash in the form of mortgages and equity lines of credit distorted the U.S. economy in recent years by creating false and unsustainable wealth.
Sure, the economy looked good. The amount of home equity that Americans tapped into made sure of that. But the value of those homes appears to have been based on an assumption that housing prices would never fall.
This has created a credit crunch that is dragging the entire U.S. economy down with it. And that credit crunch has many Americans asking the same question: Once you've hocked your home for more than it's worth, where do you turn for more cash?
Lowering interest rates isn't going to do it this time, because homeowners across the U.S. don't have anything else to hock. And even if they did, providing them with more false wealth isn't the answer, it can only compound the damage.
The fact is recessions are a normal economic cycle. There are good times, and there are bad times. Had the Fed been a little less heavy handed in their attempts to control the economy in 2001, chances are we would all be living within our means by now and maybe even have nice little savings accounts stashed away.
... And recession would be a thing of the past instead of an unwieldy crisis looming on the horizon.