Federal Reserve & Interest Rates

Over the course of the now year long financial crisis, trillions of dollars have been pumped into the money supply through either fiscal or monetary policy.  Despite the explosive growth of the money supply, many economist feel the U.S. faces a serious deflation risk and that’s because the rest of the world is struggling as well.

The Fed’s balance sheet has more than doubled as it seeks ways to stabilize the banking system where lowering interest rates alone have failed to accomplish this.  The federal government has also had a massive increase in it’s fiscal spending and faces a record deficit this year of over $1 trillion.

The economies of the world face serious contractions before things will get better.  So, despite the inflationary growth of the money supply, the majority opinion is that the Fed will lower interest rates once again this week to 0.5%.

The decline of the global real estate markets has seen a significant percentage of the world’s wealth wiped out in a single blow.  Whereas once many analysts felt the price of oil would reach $200 a barrel, now the consensus feels that we could see oil fall to as low as $30.

In the long term however, the massive increase in government debt as well as the trillion in liquidity the Fed is pumping out will put negative pressure of the dollar.  So, while the dollar has rallied the last few months don’t expect this to last and as we have seen from the past, whenever the dollar falls you can expect commodity prices to rise once again.

The U.S. faces a precarious tight rope act trying to juggle short term gains against long term repercussions.  Over the course of the past year, the government has transferred a significant amount of the risk from the financial system onto itself and taxpayers.

While the U.S. is currently benefiting from record low borrowing costs, you can’t expect this situation to last once trillions of dollars in Treasury Securities start flooding the market.

While the House voted last night to approve a $14 billion emergency bailout of the auto industry, the measure has so far stalled out in the Senate.  Without the bailout both GM and Chrysler aren’t not expected to last much past the beginning of the year.

The proposed bailout is much less than the $34 billion which the Big Three auto makers were asking for during Congressional hearings over the past month.  While the $14 billion should be enough to keep them afloat it does nothing to address Detroit’s need to revamp their production plants in order to manufacture more fuel efficient cars and compete with foreign auto makers.

While $14 billion may seem like a pittance compared to what the government has already spent on the financial system, there is major difference between the two industries.  With AIG and Citigroup which both received over $100 billion in government loans, one can realistically assume that these two companies will return to profitability once the economy normalizes, however the same can’t be said for the automobile industry which has struggled for decades.

Many people feel that even with the bailouts, the Big Three auto makers need to go through massive restructuring that is typical during bankruptcy proceedings.  The airline industry is usually the prime example used when most people think what needs to be done with the auto industry, most major airlines have had to undergo Chapter 11 bankruptcy proceeding at one time or another but were able to return to some sort of profitability.

A compromise in the Senate though will likely be reached if only because of the potential loss of over a million jobs at a time like this.  With the unemployment accelerating in the past three months the potential collapse of the auto industry would send those numbers skyrocketing.

When it’s all said and done though, it will most likely be an imperfect solution to an imperfect industry.

Although the U.S. will be adding a significant amount to the national debt this year, the one good thing is that short term borrowing costs are at an all-time low for the government.  With the economy in turmoil, investors are flocking to the safety of Treasury Securities in unprecedented droves.

For the first time ever Treasury yields fell to 0.0% and no that isn’t a typo.  Investors right now, are more worried about keeping their principal intact as opposed to seeking positive returns.

The stock market has been a big loser this year for many investors and while many stocks seem to be bargains, the reality is that a rally doesn’t seem forthcoming anytime soon.  With the global economy entering what many expect to be a long drawn out recession, the steep yield curve could persist for some time.

Even with the government’s record deficit this year, demand is far outstripping supply for one and three month Treasury Bills.  The low borrowing costs could be significant as the government will likely have another large deficit next year as well.

One of the first acts of the new administration will likely be the passage of an economic stimulus package valued somewhere between $500 billion and $1 trillion mark.  It also remains to be seen if the second half of the $700 financial rescue package will be sufficient to stabilize the banking system.

The key thing to look for is whether there will be spillover investment towards mortgage securities sold by the now government run Fannie Mae and Freddie Mac.  With the government officially backing their debt now, some investors may consider them as safe as Treasuries but with a higher yield.

Increased demand for these mortgage securities could help drive down mortgage rates, which could play a significant role in an attempt to jump start the housing market.  At this point it is difficult to see the rest of the economy improving until the precursor to our current problems is solved.