Promises from the Fed

Ben Bernanke, Chairman of the Fed, will go before the congressional Joint Economic Committee tomorrow to testify on the state of the economy.

Recent market problems have led to concerns of recession, and in the past the Fed has tried to quickly squash threats of recession by cutting rates (see 90s Greenspan). The recent housing crisis led to a half-a-point cut by Bernanke in September, which temporarily righted Wall Street.

Now, as Wall Street wobbles again, Greenspan would like to see Bernanke come to the rescue and cut rates. Bernanke has said he will not cut rates again, but promises from the Fed are as fickle as the markets themselves. This time, however, rate cuts could potentially be disastrous.

Rate cuts help banks but hurt the consumer.
Here is what has been going on: The housing market was blossoming, costs were low, people were buying homes at astonishing rates and banks were giving out cheap money loans in the form of adjustable rates. If an individual defaulted on their loan the adjustable rate would jump and the bank would take them for what little they were worth.

Unfortunately for everyone, this scheme only worked if the economy continued to boom like it did in the late 90s. When too many new homeowners couldn't pay both their shark mortgages and their outrageous credit debt the markets dropped. Consumers weren't buying and the marketplace clammed-up. Without consumers pouring money into the economy, investors became increasingly shy about giving out money, cheap or otherwise. Inter-bank lending and foreign investments dried up and the same banks that gave out cheap money found they didn't have any to reinvest of their own, let alone give out to others.

Their first reaction was to try and turn over their bad housing investments. This, of course, caused the burst in the housing bubble as banks liquidated foreclosed homes too quickly, undervaluing them and losing most of their money.

So to keep the flow of American money moving, the Fed cut rates half a percentage. This freed up cash for banks, at the expense of the discriminating saver. The rate dictated the percent gained on savings accounts yearly. Since banks would now have to pay out half a percent less, cash was freed to use in investments and inter-bank loans. This seemed rather democratic, everyone takes a small hit but the economy continues on smoothly. For a short time this was true as the stock markets rebound, but the consumer price index jumped up 0.3 percent, again placing the strain on the average American. And the burst bubble leaked on and now defaulting loans and bad credit are once again plauging Wall Street and big banking.

Cutting rates usually hurts consumers, but now it could cripple the economy.

Currently the U.S. dollar is losing value in the global marketplace. Traditionally, this is where the Fed would raise interest rates, inflating the worth of saved money and helping foreign debt-collectors remain content with keeping our "IOU"s. If the Fed does not raise rates and the dollar continues to devalue the debt will be sold off with earnest and the dollar will drop further.
Lowering rates now would further devalue the dollar.

In the past this has led to other kinds of investment within the United States. Again the 90s provide a perfect example. After the dot-com bubble burst the Fed slashed rates repeatedly and land became the stable investment. The housing market opened up, fed by the American dream and a seemingly unfailing consumer.

Today the housing market is the problem, not the solution, and while Wall Street is screaming for the Fed to cut rates again it's hard to imagine where liquid capital will come from. Even if there was money waiting in the wings, watching the dollar fall so quickly will likely keep investors shy and easily spooked, looking elsewhere for stability.

So what now?
Bernanke is in a tight spot. Either way it seems like a recession is around the bend. The Joint Economic Committee is similarly worried and hopes the chairman has a trick or two, or at the very least a plan. The hands-off approach may be the only chance the American economy has of fending off a recession (especially with Christmas season coming, the old faithful of American consumerism), but if congress trusted hands-off we wouldn't have a Fed. Maybe Mr. Bernanke can convince them they don't need one.