Tuesday, August 05, 2003

The big question of the US economy today is whether capital spending can pick up the slack generated by the end of the refi boom. GDP growth in 2002:IV and 2003:I was a paltry 1.4%, and without the Iraq occupation would have been a pathetic 0.7% for 2003:II. Thus what little real growth there has been for the last 9 months has relied heavily on the ultra-low mortgage rates which spurred a refinancing-induced consumer binge. Now that refinancing is receding sharply, will capital spending take its place?

Rising interest rates are not just a sword of Damocles hanging over the American consumer. As the NYTimes observes today,
Higher rates could also lead to more expensive loans for automobiles; robust car sales have been another pillar of the economy the last few years.

Businesses, meanwhile, still gun shy about spending money on new factories and equipment, may have to contend with higher borrowing costs as well. So will the federal government itself, just as tax cuts and spending increases are forcing it to borrow huge sums to cover the largest deficits in history.

It remains to be seen whether last week's surge in longer-term interest rates is just a blip or the start of a trend. Either way, however, it is remarkable as a demonstration of the limits of the Fed and its chairman, Alan Greenspan, to force the hand of the nation's financial markets.
Wait a minute -- "last week's surge"?? The 10-year treasury bill wound up the week ending August 1 at 4.4% and the 30-year conventional mortgage at 6.14%. But these have been shooting skywards ever since mid-June. This is no one-week blip, friends!!

The country's cheeky mortgage lenders just don't seem too keen on taking Greenspan's cue and keeping long-term rates down down down.
To protect themselves from borrowers' paying back their loans early, mortgage lenders hedge their loan portfolios in part by buying up Treasury bonds. But as interest rates began to creep up, the nation's biggest players abruptly adjusted their strategy and started selling bonds or derivative securities tied to them. Lower prices for Treasury bonds translate directly to higher interest rates earned on those bonds. . . .

as rates began to creep up last month, mortgage lenders expected a big drop in mortgage refinancing activity and began to sell off Treasury bonds. That helped push interest rates higher, creating what amounted to a vicious cycle of rising rates.
Now we hear from the financial markets how "disappointed" they are that the Fed didn't drop rates to 0.75% back in June. Right-wing stalwarts like the American Enterprise Institute complain that the Fed isn't putting the economy on "full throttle".

But consider that if the Fed does drop the federal funds rate down to 0.75%, the average money market fund in the US will suddenly be turning a profit of zero and sending a $2 trillion market out into extremely choppy waters. Cut interest rates down to 0.5% and the Fed would all but wipe out the money markets -- and you've got to believe the Fed hears the voice of the AARP on this one!

Time to start rolling out the "unorthodox" policy prescriptions again?


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