Don't Count On Another Rate Cut

This week's 0.5% rate cut by the Federal Reserve was appropriate. But I would not count on any further cuts. If economic trends run as I expect, further cuts would send the economy fish-tailing.

Much of the economy is moderately strong, including exports. The fall in new housing construction combined with the uncertainty in the mortgage derivative markets has been slowing the overall growth rate. Everyone has reason to reassess our spending habits, from private equity buyout specialists to minimum wage workers.

Hopefully the Federal Reserve cut, combined with injections of credit in appropriate institutions, will mean that mortgage rates will go a bit lower. They never were high in this decade. The problem was stupid people thought lenders would be happy with eternally low returns on their loans. Once the Fed jacked up interest rates to normal levels the handwriting was on the wall. Yet the financially illiterate did not refinance their low-interest, variable rate loans to long-term fixed-rate loans. Some people who are in default were victims of scams, but most were just spendthrifts.

There is a lot of unsold housing, both new and used, on the market. But there is a great deal of evidence of pent up demand; fear is holding buyers back. Why buy a house or condo now if it will be 10% cheaper in six months? The U.S. population increases so rapidly now that all the housing stock is needed.

Housing prices lost touch with reality around 2004, earlier in some markets. But now that developers have cut back on building (permits issued were remarkably low in August), buyers will start digesting this inventory. Already housing in the Midwest is so cheap that I would not hesitate to move a business there to take advantage of the low costs. But every market is different. San Diego, with its near-perfect weather and ocean access, will probably snap back faster than real estate in the Central Valley of California, where most people live only because they can't afford a coastal home.

With the dollar low imports should continue to boom, meaning more hiring in manufacturing and agriculture. As soon as builders start seeing their inventories dwindle they will up their output, putting demand on lumber and other housing components. Selling furniture and appliances will swing back. Of course this process is one measured in months or quarters, not days.

Unemployment is at reasonable levels despite massive layoffs in the housing sector. So if the housing sector even stabilizes, labor availability will be tight.

Of course, there is always a spread of paths to the future, and you can guess at the probabilities to match to the paths. There is some real probability of a recession, perhaps brought on by more turmoil in financial institutions. But there is a real possibility that this summer was a panic for no good reason, and that the Federal Reserve will regret even the cut it made this week.

The most probable path, in my eye, is a return to moderate economic growth in Q4 followed by strong growth in 2008. Of course as more data comes in the Fed will evaluate it, as we all will. But given the most probable path, I think the Feds should hold interest rates steady for about 6 months. Then they will probably have to raise rates again to keep all the people jumping back into real estate and stock speculation from having too big of a party.

Work smart, spend cautiously, then save, and invest wisely.