FED RATE HIKES? NOT NOW

Fed Rate Hikes? Not Now, Thanks


Markets: Everyone wants a villain to blame for the recent rocky showing by the stock market. Of course, the lousy housing market gets the lion's share of attention. But maybe it's really not to blame.

Philosophers and economists alike often sort things into "proximate" causes and "ultimate" causes — the former being those things that immediately lead to something else happening, the latter being those things that are, however distantly, the true cause of something taking place.

As such, the weak housing market and the imploding subprime lending markets are both "proximate" causes, in that they seem to be the root cause of what's happening now. Every time the market bounces, we see a spate of comments by analysts saying that the market's problems are due to "concerns over the subprime loan market" or "liquidity" or "credit availability."

True enough, as we said, these things share blame for our nasty market. But let's think ultimate cause here — the Federal Reserve.

It's pretty much a fact that each time the Fed engineers a new round of interest-rate hikes, it's followed by a spate of financial crises (see chart above). It happened in the early 1980s; it happened again in the mid-1980s and the late 1980s and early 1990s; it happened when rates briefly blipped up in 1997; it happened again when the Fed pushed rates up in earnest again in 1999 and 2000.

Those crises are brought about because, as earlier Fed rate cuts are unwound through higher rates, weaknesses become apparent.

Many companies that were profitable when the fed funds rate was at a 45-year low of 1% find they can no longer make money when the Fed raises rates to, say, 5.25% — where they are today, and have been for just over a year.

It's said that Fed moves often take a year or more to be fully felt. That's certainly the case with the rate hikes of 2005 and 2006 — which can now be seen in a tumbling stock market, weaker housing and growing doubts about the credit quality of some businesses.

Make no mistake about it: The underlying economy right now seems to be pretty solid. Growth in the most recent quarter came in at a robust 3.4% annual pace.

Consumer confidence, as measured by the University of Michigan survey, hit a six-year high in July. Job growth continues to be healthy, with unemployment at a low 4.5%, and real incomes are expanding.

These are not signs of distress. But there's no question the housing market, after an astounding run of double-digit growth, is in trouble. That has many in the markets worried right now.

According to both Fed chief Ben Bernanke and mortgage industry legend Lewis Ranieri, the subprime loan "problem" is likely to be about $100 billion in size — write-offs, losses and the like. That's a big hit, but manageable.

Let's put that in perspective.

We have a $13 trillion-plus economy. Last year, there were about $600 billion in subprime mortgages written off, out of just under $3 trillion in total mortgage activity. Overall, subprime mortgages make up 13% of all mortgages outstanding. Losses are to be expected. But, at $100 billion, the losses don't appear — at least not yet — to be leading us to financial Armageddon. They do, however, bear watching.

That said, those who want to see subprime lenders "taken down" by regulators should remember that many people own homes today only because of the subprime market.

Over the past decade, the homeownership rate has jumped from 65% to 69%, including a jump in minority ownership, thanks to subprime borrowers. We're all for correcting any excesses in that market, but in truth subprime lending is a proximate cause — not an ultimate one — for our current perceived economic woes.

We think the Fed's tightness right now is really what's behind the market's gyrations. Those who talk about the "enhanced perception of risk" in credit markets, should ask themselves this: What adds more to the risk in credit markets than the prospect of Fed rate hikes at a time core inflation (below 2%) seems well under control?

We're hearing some urge the Fed to raise rates again, fearful of what the rising price of oil and a weak dollar would mean for U.S. inflation. But a Fed rate hike would be a huge mistake.

Some $265 billion in subprime loans will be readjusted at the end of this year. If the Fed were to hike again in this cycle, things would immediately get worse, not better. And that recession we thought we had dodged might just come knocking anyway.