Cut in interest rates comes with risk

By DAVID MOON, Moon Capital Management, LLC
September 23, 2007

The Federal Reserve Board reduced two interest-rate targets by a half-percentage point this past week, pleasing both stock investors and borrowers. The Fed move came 90 minutes after a phone call with a corporate CFO in which I confidently predicted only a quarter-point decrease.

So much for my career as an interest-rate predictor. I’ll stick to easy things, like hurricanes and skirt lengths.

The Dow Jones Industrial Average was up just 70 points before the announcement. It surged after the news, finishing the day with a 336-point gain, the largest percentage increase since 2003. Banks began lowering their prime rates, the base rate on which many consumer loans are based, from 8.25 percent to 7.75 percent.

But for every yin there is a yang.

Why, when the Fed cut interest rates, did interest rates actually increase in the open market?

You read that right.

During the day that all the news was about “a cut in interest rates,” the rate on the 10-year Treasury bond increased from 4.4 percent to 4.48 percent. The 30-year bond increased from 4.70 percent to 4.76 percent.

Why?

Because there is a risk that this rate cut is inflationary.

Controlling inflation is one of the legal mandates of the Federal Reserve Board. An interest rate is simply the price of money. Like the rising cost of a loaf of bread, money inflation is reflected in rising money prices — higher interest rates.

The difference in the yields on the two- and 10-year Treasuries is the widest in two-and-a-half years. This suggests that the folks who buy and sell Treasury bonds believe that despite the latest cut, interest rates are likely to increase over the next 10 years, or at least remain steady. If longer-term rates are higher than short-term rates, current dollars are more valuable than future dollars — that is, the market is expecting a future decline in the value of dollars.

If long-term rates were zero, the market would have no expectation of inflation. Don’t hold your breath.

Foreign-currency traders also recognize this inflation risk. Just as the purchasing power of the dollar can fall at the grocery store, it can also fall on the world currency markets. With increased inflation, a dollar might buy less milk. It might also buy fewer Swiss francs. While euphoria reigned last week in the U.S. stock market, the U.S. dollar fell in value against the euro, yen, Hong Kong dollar, Singapore dollar and even the Mexican peso.

Even the Fed recognizes that this cut has risks. The statement that accompanied its action last week noted a looming threat of inflation. This language has been absent from previous Fed releases.

If you have an adjustable-rate loan that is tied to the prime rate, enjoy your rate cut. When your rate resets, you’re going to get the equivalent of a raise in your monthly pay.

But it’s possible that raise may be rendered relatively worthless, if you end up paying higher prices for the things you buy.


David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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