Smith Faculty Opinion Article

By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

January 30, 2008

Fed Interest Rate Cuts Will Not Be Enough
Sovereign Wealth Funds a Key Stumbling Block

Today, the Federal Reserve cut the federal funds rate a half point to 3.0 percent, as expected. It really had little choice.

After cutting the same rate from 4.25 to 3.5 percent on January 22, the Fed established expectations of another half point cut today. In recent months, Ben Bernanke has flip flopped so much regarding his outlook for the economy and need for further cuts, he really could not afford to disappoint market expectations again.

Fourth quarter GDP growth at 0.6 percent was a bit lower than economists forecasted but no real surprise. The economic news has been mostly bad since Thanksgiving. Retail sales have declined, industrial production and jobs creation have stalled, and new home sales and prices are dropping like stones in a well. Global stock markets are in a maelstrom, as equity analysts add up the negative prospects of businesses dependent on U.S. markets.

Sadly recent Fed moves and the stimulus moving through Congress will not likely be enough to avoid a serious slowdown in growth or even a recession, as defined by two quarters of negative growth.

Effective monetary policy requires sound financial institutions to transmit cheaper money into stronger consumer demand. Currently, banks can only write mortgages for conforming Fannie Mae loans, and for jumbos and less than prime mortgages they can hold on their portfolios. That is simply not enough to get the economy out of its malaise.

Bond market investors will no longer accept mortgage-backed securities underwritten by large Wall Street banks in the wake of the subprime debacle, because those banks have found easy capital from Sovereign Wealth Funds and Middle East Royals. These investors have not required the changes in business practices that new capital usually demands when refinancing failed enterprises with strong marketing infrastructure but soiled reputations for product quality.

For decades, banks have resold mortgages to bond investors to finance the U.S. housing market but in recent years, compensation structures and executive expectations for lavish pay have encouraged the creation of over-engineered products, the selling and reselling of the same loans, and bizarre almost inexplicable bond rating and insurance practices. The Sovereign Wealth Funds and Middle East Royals have not demanded changes in those practices, and without those, insurance companies, mutual funds and other private investors will not again buy mortgage-backed securities created by Wall Street’s financial engineers.

This situation makes monetary policy far less potent than needed at a time of crisis. It is Ben Bernanke’s job to recognize this problem and articulate to Wall Street banks the needed changes in their business practices. They could comply voluntarily, or ultimately face new regulations.

Sadly, Ben is not doing this part of his job.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.