Perhaps the Fed raised rates too much

Posted by: Michael Mandel on February 05

Here’s a thought…maybe part of the reason the credit markets are in such bad shape because the Fed raised rates too fast and too high. Think about it—they started raising rates in June, 2004. It was a quarter point increase, from 1 to 1.25. Two years later, the Fed funds rate was up to 5.25. That’s four percentage points in only two years.

And who was affected by the increase in the Fed funds rate? Well, not corporations: They saw their rates fall over this period. Conventional mortgages edged up by half a percentage point. Credit card interest rates rose by about a percentage point.

The big losers were precisely one group: Holders of adjustable rate mortgages who could not refinance into fixed rate mortgages. Did I hear someone say ‘subprime’?

Basically the Fed took a sledgehammer to the subprime sector in order to slow the economy…they should not be surprised that it broke.

In retrospect it would have been better for the Fed to have stopped at 4% and waited for a while to see what happened. If we assume that it takes 12-18 months for the effect of rate changes to propagate through the economy, they basically showed too much impatience.

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Reader Comments

Lord

February 5, 2008 06:20 PM

Or too little? The Fed had displayed its intentions for a long time. If people wouldn't pay attention, perhaps a swifter boot was indicated. It could have reduced the magnitude of the excesses. Was the Fed truly to blame though? Perhaps we just ran out of players in the financial pyramid.

Joe Cushing

February 6, 2008 03:33 AM

I see your point. I was thinking they should have done more than they did. Now I have to revise my thinking. They should have started earlier to nip the bubble in the bud. I think holding the rate so low was the real problem. The should have been able to predict a bubble would form even if they couldn't predict where or when.

Mike Mandel

February 6, 2008 08:47 AM

By the time this is all over, the Fed funds rate will look like a saw tooth--zig zag. That can't be right.

Evolved Capitalist

February 6, 2008 10:25 AM

this is a very sketcy argument with merit of hindsight but not of any logic. Most of the issues with subprime problems are with borrowers of the latest vintage 2005/2006. One can argue that Fed did not raise the rates quickly enough- because if they had, these borrowers would not have entered into speculative real estate transactions.
Also, the inflation rate during 2006-07 was increasing. But most importantly, the animal spirits of risk taking were running wild and bubbles were being created in all asset classes including, corp loans, high yield bonds, real estate, commodities etc. Fed had no choice but to increase rates or the inflation expecations whould have run wild.

Mike Mandel

February 6, 2008 11:16 AM

Not completely in hindsight. Peter Coy here at BW had a good piece about a year ago on monetary policy as a regressive tax.

http://www.businessweek.com/magazine/content/07_12/b4026050.htm

Bill J

February 6, 2008 03:25 PM

This may show my lack of understanding, but I just read Peter Coy's March 2007 article, and he doesn't appear to explain WHY long-term rates were remaining low in the face of the Fed rate increases.

It's interesting, though, to note his observation that "Most economists argue that the economy is healthy enough to withstand the problems in subprime." I guess that was before these economists understood the extent to which CDOs tied to subprime debt would amplify subprime foreclosures.

JohnH

February 6, 2008 05:50 PM

I believe they went overboard in lowering rates in 01-04. With the lower rates came lower mortgage interest, seemingly ridiculous in hindsight. This is the reason subprime borrowers could even qualify for a loan via ARMs etc. The risk factor went out the window due to these low rates and when they started to raise rates again for all intent and purposes it was still historically very low. People bought homes not according to price but by monthly payments. Thats how bubbles start, no one pays attention to the real value or
the time frame in which prices inflated.

JohnH

February 6, 2008 05:53 PM

I believe they went overboard in lowering rates in 01-04. With the lower rates came lower mortgage interest, seemingly ridiculous in hindsight. This is the reason subprime borrowers could even qualify for a loan via ARMs etc. The risk factor went out the window due to these low rates and when they started to raise rates again for all intent and purposes it was still historically very low. People bought homes not according to price but by monthly payments. Thats how bubbles start, no one pays attention to the real value or
the time frame in which prices inflated.

Bill J

February 6, 2008 07:04 PM

Sorry. My previous comment should have ended by saying, "... that was before these economists understood the extent to which CDOs tied to subprime debt would amplify THE EFFECTS OF suprime foreclosures."

I'd still like to know why the Fed rate increases didn't impact long-term lending.

Joe Cushing

February 6, 2008 10:28 PM

It's worth pointing out that the fed is not the only player in the interest rate game. How much of what they do is a reaction/mirror and how much is actual driving?

Mr. Bob

February 6, 2008 11:50 PM

The Fed raised rates too high eh? Perhaps you are not familiar with the concept of inflation = the devaluation of the dollar.

The dollar lost 17% of it's value to the Euro last year, and who do you suppose pays for inflation? Everyone pays for inflation. People on fixed incomes really pay the price. But you are concerned with people who took out loans that they should have known they couldn't afford? Hmmmmmmmmm.

That is very interesting indeed. If I were a business major as opposed to a creative writing major, I might have been tempted to call you... a name that implies a lack of intelligence perhaps?

I suppose people who take out interest only loans and think they were purchasing something as opposed to renting were also mistreated by the Feds decision to not destroy the value of the dollar?

Now the Fed is in panic mode and everyone is paying the price. Well... anyone who has to eat or drive that is.

Murali Thoota

February 12, 2008 04:53 PM

I like this contrarian view on the Fed rates. I have seen people debate about the fault of Greenspan of lowering it to a level where in it created a bubble. That was right. But he shouldn't have increased them so fast.

I guess more than 50-70% of ARM Mortgage holders didn't even envisage this is going to happen. If you make an analysis of the 'subprime' holders, you might see 50% of the people may not be having math skills to even calculate the intended mortgage payment if their interest doubled.

I agree that Fed raised them too high (relatively to where they were earlier) and too fast.

Norm Barnes

February 25, 2008 03:39 PM

Anybody Home. Rates are an effect of other economic actions. Rate Action up/down does not move the market directly. If I am Peking U investor counting on a lower yen to make it attractive to invest in the US Bond or Dollar a lowering of the Bond yield does not excite me to keep my monies in US Instruments particularly if it has the impact of raising the value of the yen. I would tend to be a contrarian to make money. Real wealth is in spending power and spending power improves as cost decrease -- I doubt if any consumer will ever see the benefits of a lower investment dollar because there are too many pigs who will skew the benefit well before it reaches any consumer. We have taught our prodigy's well. Live for today and "to hell" with all that is simple and honest. Install a higher morality and ethics in Government and we might be on the right track otherwise look to the future of an "Escape from Freedom".

pete

November 13, 2008 02:55 AM

Did the Fed underestimate the impact of rate hikes and the potential losses to financial institutions holding ARM loans and the impact on homeowners and the probability of astronomical foreclose rates and bank losses? Did they miss that in their analysis prior to raising rates? It seemed like they were more worried about the inflation #'s.

Thank you for your interest. This blog is no longer active.

 

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Michael Mandel, BW's award-winning chief economist, provides his unique perspective on the hot economic issues of the day. From globalization to the future of work to the ups and downs of the financial markets, Mandel-named 2006 economic journalist of the year by the World Leadership Forum-offers cutting edge analysis and commentary.

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