Federal Reserve & Interest Rates

Although we’ve already seen the U.S. government pump trillions into the financial system to prevent it from collapsing, it is by no means out of danger.  Unfortunately, financial markets will most likely be in a precarious position for many years to come.

Investors have already shown some concern over the long term implications of the government’s massive debt load and in the past month yields on 10 year Treasury Securities have started to rise.  Despite the fact that global demand is weak and is expected to remain that way for some time, we have also seen commodities markets start to creep up as well.

Inflation concerns will likely hound the U.S. financial market for years to come.  It can’t hide from the fact that Treasury yields will most likely rise in order for the U.S. to fund it’s financial recovery plan.

This will have a spillover effect on consumer interest rates and will affect bond markets for years to come.  The primary weapon to fight inflation is to raise interest rates but while that may keep inflation in check, it also serves as a severe handicap to economic growth.

There are no free lunches, so while the government’s massive intervention may have kept it from collapse in the short term, that same intervention will most likely keep it in a weakened state for quite some time.  For now the dollar has kept it’s place as a reserve currency for the rest of the world but how long that will be the case remains to be seen.

The next few years will be very important, the severe debt load of the U.S. government was already a problem before the recent massive increase and will have to be dealt with sooner rather than later.  While technically the funds the government used to save the financial system were loans and are expected to be paid back, they face a significant risk of losses due to defaults.

A number of federal agencies with the Federal Reserve and the Treasury at the forefront, will face a difficult balancing act over the next few years in order to maintain the stability of inflation and interest rates and it’s overall effect on economic growth and the financial system.

Chairman Ben Bernanke gave testimony before the House of Representatives on the current economic outlook and the status of the federal budget.  Fiscal and monetary policy face a stiff challenge in the next year in trying to end a recession that has already seen the economy contract by about 6% and the federal budget balloon to mammoth proportions.

Conditions in a number of financial markets have improved since earlier this year, likely reflecting both policy actions taken by the Federal Reserve and other agencies as well as the somewhat better economic outlook. Nevertheless, financial markets and financial institutions remain under stress, and low asset prices and tight credit conditions continue to restrain economic activity.

The government has pretty much fired it’s bolt, any more additional spending could have adverse affects on long term pressure on interest rates, which started rising in recent weeks.  It’s still to early to tell if rising mortgage rates will send the housing market, which has shows signs of bottoming out in recent months, into another tailspin.

The biggest obstacle to additional spending will be the growth of the federal debt to GDP ratio that is already expected to reach post-World War II levels in the next two years.  Over half the banks, 10 out of the 19 largest banks surveyed by the Treasury will require more capital and will need a plan to raise it by the November 9th deadline.

With the housing market still in flux, potential losses to banks still remains a grave threat to the stability of the financial system.  The Fed still expects the economic retraction to bottom out by the end of the year but even the most favorable projections predict a long road to recovery.

As President Obama takes office, all of Wall Street will be watching to see if his new proposed stimulus package will be enough to turn around a floundering economy.  Estimated at somewhere around $850 billion, together with the second half of the bank rescue funds of TARP, they will try to stabilize a financial system that has been frozen since the fall. 

Lending has ground to a halt as many financial institutions try to shore up capital because their balance sheets are filled with hard to value assets with the breakdown of securitization markets.  As financial institutions continue to de-leverage themselves, the existing credit pool will continue to shrink.

The flow of credit needs to be re-established and a portion of the TARP funds is planned to be used to forestall rising foreclosures.  The recovery of the housing market will be an essential first step for any turn around of the economy.

Consumer spending has taken a big hit as Americans’ confidence in the economy continues to wane.  Once funds from the stimulus package reach the general public, spending should be propped up for a few months as was the case with the previous stimulus package. 

Unemployment figures are also quickly becoming a major concern with the economy losing jobs for the twelfth straight month.  Those figures would have skyrocketed were it not for the government rescue of the auto industry in December.

We haven’t seen this kind of government involvement in the economy since the Great Depression and despite the increasing similarities to a state run economy, there is widespread public support for the government’s actions.  Many Americans have lost trust in the system and it will be up to the government to regain that trust.