The Fed: Why They Can and Cannot Raise Rates

On June 28, the Feds met once again to discuss key issues on whether or not to raise the key short-term rates aka Federal Fund Rate. A few issues that were topics of discussion were the usual inflation and the overall economy. As some may speculate the something HAS to happen soon do to the lack of increase or decrease lately, you must remember something. History suggests that it is not uncommon for the Fed to leave rates alone for a while. From September of 1992 to February of 1994, the Feds held rates at 3% which is a span of 17 months. And more recently, from June of 2003 to June of 2004, rates were held at a real estate attractive 1%.

One of the most important factors on why the Feds did not touch the rates is because right now, the economy will likely not be able to withstand a rate hike. Currently, there are a number of sectors of the U.S. economy that are pretty weak. The number one factor which most now know are the housing and construction markets. Right on its tail is the auto, retail, banking, and investment banking industries.

As hard as it is for me to say, because my business thrives on low rates and aggressive financing, the Feds, starting with Alan Greenspan made the smart move and raised rates constantly for over a year. Because of low rates, the inevitable factor that transpired was overbuilding. In conjunction with overbuilding, banks lent money to the second home and investor market. Since February, banks have started seeing the negative impact on their leniency on loans. While banks are getting much more conservative, they must still face the fact that they are dealing with having financed too many homes to people who cannot make their payments. With banks becoming more conservative, the economy has been at a snails pace, and even saying that is a compliment. If the Feds were to boost rates, the housing market would weaken further and homeowners would inevitably face foreclosures, and the banking industry would see a problem get much worse.

So to not confuse you on terminology about different factors of inflation, I will keep it simple. On the flip side of the coin from the previous paragraphs, on one of the major factors on why the Fed cant CUT rates is because if rates were cut, the U.S dollar would drop. Our friends in Europe and Japan would be crying the blues to us because a lower U.S dollar would hurt their economies, simply because it would make it easier for U.S companies to export product and services there.

Rates are increasing at the major banks in Europe. Their reasoning coincides with ours, which is to keep rising property values in check. Remember in 2004 when the real estate market in Florida was red hot? We had a record number of Europeans buying investment properties over here. Money was cheap, and they knew they could not get the same value for their dollar over there than they could over here. As the markets have somewhat balanced, you are now seeing overseas investors easing up quite a bit.

For those of you keeping track of the Consumer Price Index, it looks like an odd number. This is in part because it does not include those items such as food and energy which are the top dogs of inflation. If unnoticed, these two factors can become part of the core inflation in the economy.

If the Fed does not threaten us with inflation, the financial market will not take the Fed seriously about approaching inflation, leading them to believe that we will not cut the rates.

The truth is, no one really knows. Quarterly reports can be speculated upon, but until good old Ben Bernanke meets with the rest of the Federal Reserve, we will know whether to cringe or jump. Although there is speculation that the rates could change later this year, my opinion is going to be the first or second quarter of 2008.

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