Alright Bernanke, Enough with the Rate Cuts

Do you get the feeling that FOMC Chairman Ben Bernanke is lowering interest rates more because that is what the markets want, and less because it is actually helping the problems we have in the housing and credit markets? The debate has long been whether or not the mortgage crisis will be contained or spread into the rest of the economy and cause a recession. With third quarter GDP growth coming in at 3.9%, the highest rate since early 2006, it is clear that the economy is a lot more than just the housing market.

While GDP growth should slow meaningfully in Q4, it does appear the mortgage problems are contained. Unless rate cuts will help stabilize the housing market, which is not a likely result, I don’t see the need to go ahead with them just for the market’s sake. After all, commodities like gold, oil, wheat, corn, etc are soaring. The result will be higher prices for consumers, which we have already begun to see as companies like FedEx, Colgate, and Procter & Gamble are all raising prices to maintain their profit margins and stock prices.

In the face of apparent inflation pressures, interest rates could ultimately be headed higher, which would make the recent cuts even more baffling. It’s true that the government’s inflation data doesn’t seem to jive with reality, and maybe that will reduce the likelihood that rate increases are in our future, but when press release after press release announce price increases from major manufacturers due to record commodity prices, it’s hard to deny inflation is real.

So what will cure the housing market’s woes if rates cuts won’t do the trick? Honestly, just the laws of supply and demand. The housing market is still falling with no signs of stability in sight. As long as delinquency and foreclosure rates continue to rise, and home prices continue to fall, the credit market issues (loan losses and asset backed securities writedowns) will continue. The value of loans won’t stop falling until the performance of such loans improves, or at least stop deteriorating.

Rate cuts won’t help because they have no direct impact on home prices or mortgage delinquency rates. This will be apparent when we see fourth quarter loan performance continue to get worse, not better. As home inventories are worked off and more home owners refinance into fixed rate loans, the markets will eventually stabilize. It will take time though. I don’t know when, nobody does, but hopefully we can get there by the end of 2008.

As for whether the housing market weakness has spread to other areas, this debate obviously will continue. From third quarter earnings season we see that the weakness has really been contained to home builders, mortgage lenders, banks and investment firms that own securities backed by mortgage loans, and companies that provide insurance for mortgages and mortgage backed securities. It is my belief, and many will certainly disagree, that consumer spending is not as bad as some would have you think, and the fact that growth in spending is lackluster has much more to do with the face that real wages have been stagnant for years, and not because of the housing market. In addition, the fact that consumers are staying current on all their other monthly bills, even when they are delinquent on their mortgages, shows that the housing market’s issues really are fairly well contained.

As for policy moves, I think actions should be focused exclusively on stabilizing the housing market. While pleasing to the markets, I don’t see any direct impact on housing from rate cuts. Just imagine how great it would be if we could get back to a “normal” housing market. People would have to get used to not making much money on their homes (real estate returns historically don’t outpace inflation), but the credit markets would stabilize and corporate earnings could resume their growth trend. Even a flat housing market would be welcomed by investors, to say the least.

Full Disclosure: No positions in the companies mentioned