Fed Rate Cuts Propping Up Asset Values
by Travis Pantin
Mon, 28 Jan 2008 at 11:24 AM
The Federal Reserve interest rate cuts have as much to do with trying to prop up asset values as with stimulating economic growth, a Washington economist, Thomas Palley, writes.
"Let's not fool ourselves about Wall Street and free markets. The Fed is using its government granted power of fixing interest rates to bail out Wall Street. That is welfare, Federal Reserve-style," he writes.
A less-recognized effect of lower interest rates is that they increase the price of fixed income assets. When interest rates go down, Mr. Palley explains, bond prices go up, which raises the price of such assets.
Mr. Palley describes the chain reaction that the Fed is attempting to forestall: Perceptions of heightened default risk on mortgages and consumer debts have caused securities backed by these assets to depreciate. That, in turn, has caused huge losses at banks and insurance companies, which has placed them in danger of regulatory insolvency and even bankruptcy.
The problems affect bond insurers in particular, threatening them with a downgrade in credit ratings. "If the bond insurers are downgraded, this could trigger a cascade of losses that could fracture the system. This is because insured bonds would fall in value, thereby wiping out further capital," Mr. Palley writes.
So far, the Fed's attempt to halt this process has not been successful: Default rates on mortgages and consumer debts have been rising as quickly as the Fed has been cutting interest rates.
Mr. Palley argues that the real problem is that the existing system of regulation, meant to discipline risk-taking, has proven inadequate. "The problem is individual firms do not take account of the impact of their risk-taking on others, so that the system takes on too much risk," he writes.
Remedying this failing would require "deep regulatory reform that is nothing less than paradigm change," according to Mr. Palley. The Fed will resist this, he says, but until it happens, the "welfare for Wall Street" problem will persist.
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