Fed's Interest Rate Cuts May Not Bring Strong Economy

As the Fed begins to cut interest rates, it is important to consider the possibility that lower rates will not produce a stronger economy. We only need to look at Japan to see the proof an economy is about far more than just interest rates. Feeding into this is the Fed's limited ability to directly determine rates at the long end of the curve.

Lower rates have almost been guaranteed and promised, however, we should never forget that liquidity is far more important. This is why a past article here on AdvancingTime touted the idea more focus should be placed on liquidity rather than interest rates. When you need money, whether the amount is small or large, not being able to get it can lead to a life-changing or grave outcome. Yes, it is possible rates can fall at the same time credit tightens. This can result in dire consequences.

Contagion is a word used to describe how a disease is passed from one individual to another. It is also used to explain how problems in one area of the economy tend to spill over into other sectors of the economy and markets. When it does it can occur quickly and be devastating to the financial system. This is why it would be wise to remember that if you have good credit you will always be able to get a loan a myth.

People learn in a credit crunch that liquidity is far more important than interest rates. Many years of an easy credit environment have numbed people to the reality that credit is not a guaranteed right. This is a reality that can hit us like a slap in the face. 

Part of what we will see in the coming months could be simply an adjustment in the flow of capital to those who want it most or can afford it. Much of what may develop is a lack of willingness to lend based on the possibility the risk of not being repaid increases in a difficult economy. This has the potential to create a self-feeding loop in a credit-tightening cycle. Halting such a damaging loop can come down to the Fed's questionable ability to get banks to lend during adverse conditions.

The notion you stand a snowball's chance in hell of getting a loan in an environment of credit tightening has yet to dawn on many people. The existence of so-called "loan sharks" underlines the idea that if someone is desperate to borrow money they will often put themselves in danger to do so. Loan sharks, which generally operate outside the law, offer loans at extremely high interest rates and have strict terms of collection if the loan is not repaid. 

Most people have not experienced cycles of severe credit tightening and may have difficulty imagining such a scenario. This is partially due to what may be considered "memory bias" or "recency bias." This can result in confusion as new situations arise. Memories tend to be clouded by people incorrectly believing that recent events will likely occur again. This tendency obscures the probability the future may be quite different from the past and leads people to make poor decisions based on the recent past.

Like many businesses, the banking sector has changed over the years. The banking industry is far different than it was a few decades ago. As a financial institution, banks are licensed to accept deposits and make loans. Not only do banks protect our money, they lend out this money to create profits. But they also perform a lot of other financial services. That said, banks are not shy about placing upon customers a lot of fees and other charges.

• The three main business segments for a bank are retail banking, wholesale banking, and wealth management.
• Retail banking or personal banking involves deposits, mortgages, loans, and credit cards.
• Wholesale banking is related to sales and trading and mergers and acquisitions.
• Wealth management generates revenue through retail brokerage services and asset management.

The simple and ugly truth is banks are not "good neighbors" there to serve and be concerned about the community. Banks do not make much money on small loans at low-interest rates. The cost of making these loans far outweighs the income flowing from them even before factoring in the risk of default. This is why most small businesses must turn to other sources in order to find financing and a lot of these are loans "hidden off the balance sheet" at much higher rates. When push comes to shove, the banks will be fast to throw you under the bus. Adding insult to injury, if you have put assets up with them as collateral, they may be inclined to seize them if doing so plays to their advantage.

Interest Rates Have Fallen Over The Decades

 

This swings back to the title of this piece, interest rates are still very low compared to those we experienced during the 80s and 90s. To someone in need of a loan even a few full points of interest is often not as big a deal as the availability of credit. When credit windows slam closed people get scared and shadow banking or unregulated lending soars.

Liquidity is the lifeblood of commerce. The massive growth in the financial sector versus Main Street, the GDP, and the real economy has made debt a major concern. Credit markets will be coming under a lot of pressure as a great deal of this debt coming due. Adding to the problem is that much of it is short-term debt that must be rolled over or extended. It will be interesting how this plays out in a "risk off" environment. It is just one of the factors helping to determine where investors park their wealth and in what form.

Lately, the Fed has been boxed in by the hyper-reaction of investors to anything it does. It needs to get investors to refocus on profits, margins, and risk. The combination of cheap money, and too much of it, has fueled speculation and blown the lid off markets in recent years. It seems that greed has overshadowed the degree a tightening in credit standards can impact the economy. This is partially due to either the Fed's or the government's willingness to generate stimulus that promotes the wealth effect.

The growth generated from low-interest rates and easy credit has some drawbacks. This takes us to the issue of where the stimulus is coming from. Consider that stimulating the economy through monetary policy and stimulus from fiscal spending have different long-term implications for inflation. It also impacts the economy in a big way, especially when it is not geared towards increasing productivity.

This has fostered an environment where the stock market has been less efficient in discovering the true value of companies. While recessions halt inflation the issue is just how much irreparable damage it will inflict on Main Street and society as the "lag effect" hits us in the face. The stock market is not cheap, earnings will most likely fall takeing stock prices with them. In response, expect tapped-out consumers to cut back on spending, unemployment to rise, and a lot of small businesses to fail. 

A lack of liquidity can be poisonous. When you need money, whether the amount is small or large, not being able to get it can lead to a life-changing or grave outcome. It is important to point out that housing values are a far bigger issue for most Americans than stocks. Still, these markets do influence each other. Dealing with a "bubble economy" is always a problem and results in investors and people, in general, to buy high and sell low, often with devastating consequences.

 

(Republishing of this article welcomed with reference to Bruce Wilds/AdvancingTime Blog)