Fed Cuts Discount Rate From 6.25% to 5.75%
Dow Rallies +233 Points on Friday Because of Fed Intervention
August 19, 2007
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By: Jerry Cole - Retirement, Investment
Fed cuts interest rate - Makes money available for banks to loan.
Along with cutting the discount rate to 5.75% from 6.25%, the Federal Reserve Friday also signaled a willingness to cut interest rates if necessary. The latter indication may have had more to do with the market rally on Friday than anything else.
What the Fed did in cutting the discount rate was to encourage banks to borrow and thereby make more money available for the banks to loan.
To lower interest rates in general, the Fed would need to lower what is known as the federal funds target rate, which is the rate at which banks lend to each other over night to square their books. Many traders believe this is what the Fed will do on or before their next meeting on September 18th.
The markets reacted with great enthusiasm to the Fed intervention. The Dow Jones Industrial Average was up more than 300 points early on and managed to close at 13079.08, up 233.3 points.
Will these moves by the Fed calm the volatility in the markets? It seems that the high risk takers always look to the Fed to bail them out. This creates a dilemma for the Fed and is known by financial people as "moral hazard".
Moral hazard is an old economic concept with its roots in the insurance business. The idea is: if you protect someone too well against an unwanted outcome, that person may behave recklessly.
Someone who buys extensive liability insurance for his car may drive too fast because he feels financially protected. If investors believe the Fed will rescue them from their excesses, they are more likely to take unwarranted risks.
If the Fed were to cut interest rates now, it would certainly ease the credit tightening we are experiencing. It would make it easier to buy stocks that have been beaten down. But would such a move encourage more speculation and create an even bigger bubble later?
On the other hand you don't want to see the economy slow so much it would fall into recession. The Fed determination to fight inflation and stay the course on interest rates for over a year has slowed the economy to be sure. But is this what caused the subprime debacle?
At this point the market has undergone a normal correction. A move downward of 10% is referred to as a correction and the market hit that yardstick momentarily this week. If, in fact, the market resumes some normalcy, the correction will have served to clean out some of the excesses that were present before the correction started. This would give the market a stronger foundation.
The subprime crisis will, more than likely, take some time to correct. The subprime lending market produced the nation's second all-time high level of foreclosures since the United States savings and loan crisis of the 1980's.
However, according to Grubb & Ellis real estate company, some 18 states have housing markets that are appreciating. Some 56 percent of the nation's real estate markets are appreciating or have stabilized.
The United States population is expected to increase by more than 20% by the year 2030. It has always been the American dream to own one's home. The markets will adjust so that the dream can come true for many.
But first the markets have to take out the easy money and greed that has led to the present credit crisis.
Remember your fundamentals. You can't control the market - but you can control your reaction to it.
I invite your questions.
Or Contact Jerry Cole at:
(The opinions expressed are solely those of the author and not Gen worth Financial Securities Corporation.)
509 Center Ave, Suite #102, Bay City, MI
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