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Economic Review

6/30/09

Why any substantial Fed tightening in the near term is not very likely.

Last week there seemed to be an overhanging expectation that the Fed may actually raise rates, albeit even 25 basis points, to signal to the marketplace that the worst of the economic crisis was over and that more positive times were coming.  The US Dollar even posted gains into the FOMC meeting. But as we all saw, there was to be no change in monetary policy and rightly so.

Despite the media hype that the recent stimulus monies are beginning to impact the economy and the rate of decline of various data series is moderating, reality is that banks are finding it difficult to achieve noteworthy earnings in the current market of borrowing and lending.  Given the recent dramatic increase in longer term interest rates, mortgage activity has slowed and refinancing activity has simply evaporated.  Any substantial increase in short term rates would exacerbate banks’ inability to achieve sizable returns as margins would shrink.  The squeeze on margins would be higher costs for banks to borrow money (e.g. pay out higher rates to depositors) while lending activity would decline given any marked increases in long term rates.

A major factor to reviving the beleaguered real estate market is to keep mortgage rates low, where 30 year rates above 6% to 6.5% are resulting in a change in elasticity in borrowing (e.g. substantial reductions in borrowing to purchase homes with rates at the 6.5% level).  A Fed tightening of any substance would heighten this affect.

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