Too much hope?

From the Wall Street Journal:

Too Much Hope
May Be Pinned
On Rate Cut
September 17, 2007; Page A1

Investors are putting a lot of hope in the Federal Reserve’s ability to ride to the rescue tomorrow.

Maybe too much hope.

Though the stock market surged last week on optimism that a widely expected interest-rate cut by the Fed would boost stocks, such a rate cut would offer little immediate help for the fundamental problems weighing on the nation’s economy and financial markets. These include a worsening housing slump and high gasoline prices, which are damping consumer spending, and fears of further defaults on the billions of dollars of low-quality loans that have been used to finance mortgages and corporate takeovers.

Even if the Fed carries out a series of rate cuts, the economy and stock market are likely to be dealing with the fallout from these problems well into next year.

Financial markets view it as almost a certainty that the Fed will cut its target for short-term interest rates tomorrow, perhaps by as much as half a percentage point, in an effort to perk up credit markets and economic growth. It would be the first cut after 17 consecutive quarter-point increases that took rates from an exceptionally low 1% in June 2004 to 5.25% in June 2006, where they have remained since.

Based partly on the market’s rapid recovery after Fed rate cuts during the 1998 credit crisis, many money managers are betting stocks will surge if the Fed cuts rates now. That helps explain last week’s strong stock gains, including the week’s 329.14-point, or 2.5%, rise in the Dow Jones Industrial Average to 13442.52.

But some economists worry that expectations have gotten out of hand. What ailed stocks in 1998 was the combination of Asian economic woes and a Russian debt default, which contributed to the near-collapse of a huge U.S. hedge fund, Long-Term Capital Management.

Unlike in 1998, when the real troubles were imported from abroad, today’s problems are home-grown: the housing meltdown and the credit crunch that has followed.

Even if the Fed acts quickly and cuts rates more than once this year, as many economists now expect, the impact on the economy would be slow to take hold. Indeed, the housing crunch may get worse before it gets better. So, instead of taking off like a rocket, as it did when the Fed cut rates three times in the fall of 1998, the U.S. stock market may have to navigate more difficult seas.

“The bounce-back in the financial markets is probably going to be smaller than it was in 1998,” when the Dow Jones industrials surged 20% from its close on Oct. 1 through the end of the year, says Jan Hatzius, chief U.S. economist at Goldman Sachs Group Inc. “We should expect further problems in the financial markets from the housing troubles.”

“The recession in housing shows no sign of ending, undercutting the momentum of the economy,” says Ethan Harris, chief U.S. economist at Lehman Brothers Holdings Inc. “We are likely to see consumer spending slow down.” Because consumer spending accounts for more than two-thirds of U.S. economic activity, it is important to growth.

In the near term, however, the big problem is that it takes months for rate cuts to translate into economic growth, by affecting things such as investment, consumer spending and exports. In credit markets, some banks have become less willing to extend credit for purposes like takeover financing, because of a fear of default. A quarter-point or half-point change in base rates isn’t going to change that very quickly.

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3 Responses to Too much hope?

  1. chicagofinance says:

    no duh!

  2. lisoosh says:

    Nothing like dashed hope to provide a cold splash of reality.

  3. Karl Zachar says:

    We all understand that the actual one-time rate cut of 25bps (or even 50bps) will do little to turn around the slumping US housing market. However, what the market is looking for is a signal from Mr. Bernanke. Wall Street doesn’t yet understand how Bernanke thinks. If he cuts the Fed Funds rate today, he’s telling the market that he won’t let the economy slow down further.

    No matter what, a rate cut is not an automatic rally call for the US equity markets. We could even see a down market this afternoon if Bernanke cuts (as everyone expects).

    What would I do if I were Bernanke? I would stay on the sidelines. There’s too much risk to cutting rates now. Just look at commodity prices (oil, gold, etc.). Cut now and risk inflation later.

    Stay tuned.

    Karl Zachar

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