WEEK OF DECEMBER 17, 2007—IS FEDERAL RESERVE RIGHT?

The Federal Reserve Open Market Committee lowered its interest rates one-quarter percent, causing a stock market selloff. Why didn’t the Fed’s action cheer the markets? Because it believes there is no recession looming on the horizon, while Wall Street sees the danger of a recession next year. Therefore the rate drop disappointed investors and resulted in a flight to the safety of Treasury bonds. This means longer-term fixed rates could continue their recent descent.

The FOMC statement said, “Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks. Today's action, combined with the policy actions taken earlier, should help promote moderate growth over time.”

Part of the problem is the confusing signals put out by the markets. For instance,

the Mortgage Bankers Association put out a highly deceptive headline, “US Mortgage Foreclosures at Record High.” There were 1.69 percent of homeowners somewhere in the foreclosure process in Q3, while 5.59 percent of all mortgages were more than 30 days late on their mortgage payments.

Although this is clearly a sign that many borrowers are in trouble, 1 percent is the historical average for foreclosures of conventional loans, and 4.25 percent the average for those at least 30 days in default of their payment. So foreclosure rate are up by one-third, or 50 percent.

But 43 percent of all new foreclosures are in subprime adjustable-rate programs, and they comprise just 6.8 percent of all outstanding mortgages. So if we take out the recent spate of subprime originations, the majority of which occurred over the past 2 years, then we are back to historical averages for so-called prime mortgages!

The debate is whether the ongoing credit crunch--precipitated by the subprime debacle—will brake the overall economy. Economists are predicting just 1 percent GDP growth for the fourth quarter, a very drastic slowdown from Q3’s 4.9 percent growth. This is because they believe consumer spending will also grind to a halt.

But in fact spending was rising 5.2 percent in Q3, and consumers in October borrowed $6.4 billion more on their credit cards, a 2.5 percent jump, according to the Federal Reserve. Top this off with same-store retail sales rising 4 percent in November, and we see much better growth closing out this year.

We also had a good employment report in November, with 94,000 more payroll jobs created and the jobless rate holding at 4.7 percent. The household survey that actually determines the jobless rate showed a huge 696,000 job increase, including the self-employed. The unemployed and out of the labor force totals also shrank, indicating increased activity, rather than an impending slowdown.

The credit crunch seems to be largely self-induced by Wall Streeters that has the potential to affect their bottom line for several quarters, but not the overall economy.

Copyright © 2007