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Fed reductions welcome news, but…

Recent action by the Federal Reserve to cut interest rates by a half point to 4.75% won’t be a cure all for economic woes including a decline in new home construction and the record levels of home foreclosures. But the action is expected to have major benefits.

“The rate reduction should stimulate a lot of things from homebuilding to commercial to consumer activity,” said Dave Dennis, chairman of the New Orleans Federal Reserve Board, which encompasses parts of four states in the South. “A 50-basis-point change in its own right will not completely drive the housing market or necessarily make a commercial project viable. But it certainly is a catalyst to signal to many developers and project oriented people that it may be close to time to push the go button on their projects.”

Dennis said the action was not necessarily a reaction to the subprime mortgage concerns. It was an evaluation and positioning for the overall economy.

“My sense would be it is a good move, and a timely move for the benefit of Mississippians,” said Dennis, who is president of Specialty Contractors and Associates Inc., Gulfport. “The Federal Reserve has been very cognizant of the economic environments we all operate within and has tried to be adaptive to the specifics of the economy. When the insurance issues of affordability and availability are clarified and solved, that in combination with an accommodative Federal Reserve position should stimulate significant economic activity in Mississippi.”

When the Federal Reserve changes interest rates, it is focused an implied target rate. Dennis said the target is achieved by buying and selling bonds in the open market so that supply and demand of money actually achieves the targeted or implied interest rate. It generally takes many months for the impact of the rate changes to filter through the economy.

Inflationary worries but…

There are always concerns a rate reduction could increase inflation. But the Fed took that into consideration, said Mississippi Banking Commissioner John Allison.

“Obviously the Fed still had some inflationary worries but not enough to not do this,” Allison said. “This is going to be a spurt to the economy, and we saw that with an almost 400-point rise in stock market. The 50 basis points was another strong statement. If it had only been 25 points, the markets would have reacted negatively. They had already built in 25 points.”

Because the action affects interest rates for mortgages and credit card companies, rank-and-file consumers in Mississippi are going to have more money in their pocket to spend or invest. Some adjustable rate mortgages (ARMs) are tied to the Fed rate.

“Some consumers could see their mortgage payments go down,” Allison said. “So I think it is good overall. We certainly don’t know what the Fed is going to do later on, but I think we might even see one more rate cut before the end of the year which, again, would continue to spur things along.”

Banks buy and sell money. So if banks are loaning at a lower rate, they are also going to be buying it at a lower rate. That means there could be a drop in the savings rates, as well.

“That is the other side of down rates,” Allison said. “That is probably the only negative effect to it, but everybody adjusts to that.”

Allison said the underlying statement to the Fed’s action was to help bolster or counteract some of the adverse publicity about increased foreclosures in the subprime mortgage market. While there aren’t a lot of subprime mortgages in Mississippi, the lower rates could be beneficial to those who do have ARMs.

While the stock market responded favorably to the cut in interest rates, bond market reaction was mixed, says Ashby Foote, president of Vector Money Management Inc., Jackson.

“While shorter maturities rallied a bit, the yield curve, from five years to 30 years, suffered a sharp sell-off,” Foote said. “The 30-year Treasury yield went from 4.7% to 4.97%. Such a negative reaction suggests that the bond market is now worried about the prospect of inflation around the corner. This concern is corroborated by a big spike in gold, which hit $734 an ounce, its highest price in 26 years.”

Foote said there is always a lag between monetary policy changes and the impact on the economy. He said it should take 12 to 18 months for this latest cut to work its way through the economy.

“The markets’ reaction has to be considered a vote towards higher inflation,” Foote said. “In addition to gold spiking up to a 26-year high, other commodity prices also traded higher. Oil also spiked up, closing at an all-time high of $83.33 a barrel. A hazard of just watching the C.P.I. and P.P.I. numbers issued by the government is the fact those indexes include lots of items that have stickier prices that take months or years to change in price. It is clear to anyone that buys gasoline or groceries that prices have been heading higher.”

Toward equilibrium

He doesn’t see the half-point cut as a cure-all for the ailing housing market. Unfortunately, more homes have been built than the market is prepared to absorb right now and it will take some time to reach equilibrium.

“There is still a glut of housing on the market, much of it higher-end housing that many people can’t afford,” Foote said. “Housing isn’t monolithic — you have different price points and different communities. Some will do fine and while some areas may take years to recover.

“The fact is over the past five years, we have built more residential real estate than we have demand for. We have too many rooftops and too many rooftops at the wrong price point. In many markets, there are more $400,000 houses than people who want to own $400,000 houses. Some have been financed for people who perhaps can’t afford the amount of house they bought. Lowering the Fed funds rates doesn’t solve that because you still have too much housing. It is going to take a while to work through that surplus.”

Foote likened it to the savings & loan (S&L) crisis in late 1980s when too much real estate was built with the help of S&Ls. In that case, there was overbuilding in the commercial real estate market. This time it is residential real estate that has been overbuilt.

“While the cut in the interest rate has been received well by the stock market, that doesn’t solve the underlying problem of the excess of residential real estate whether condos in Florida or other high priced real estate in other areas of the country,” Foote said. “That isn’t to say that is going to derail the economy and cause a recession. It just means there are going to be problems in those specific areas.”

One of the positives right now for the economy and the stock market is the strong growth overseas. Foote said the U.S. export business is going great guns and should continue to be a big driver of corporate earnings and hopefully stock performance.

Contact MBJ contributing writer Becky Gillette at bgillette4@cox.net.

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