With another reduction in the fed funds rate coming tomorrow afternoon, we have another chance to review the effects of the Fed's now-aggressive rate-cutting campaign.
We can say with confidence that lower fed funds means better net interest margins for banks. Thus the recent rally in the beaten-down XLF (see the one-year chart below, with a 20-day EMA in blue). But keep in mind that the financials have rallied a couple times before resuming the deterioration that began in June.
We can also say that a fed funds cut will produce a lower prime rate, as borrowers' equity lines of credit (HELOCs) reset at lower levels in relatively short order. In this sense, a lower fed funds rate will help borrowers service certain parts of their existing debt loads. That's no trivial thing. But the debt service--and credit contraction--story doesn't end there.
Here's a key passage from a recent BusinessWeek story on consumer spending (emphasis added in bold):
Fearful bankers are making matters worse by tightening their lending standards, which makes all sorts of consumer loans more expensive and scarce. The banks' caution comes out of sheer necessity. Their balance sheets are devastated after the huge mortgage write-downs of the last two quarters. And the industry's new conservative lending posture will make it difficult to resuscitate consumer spending with another jolt of interest-rate cuts. Banks are likely to keep raising rates on credit cards and other consumer loans no matter what Federal Reserve Chairman Ben Bernanke does.
Once again, it's lending standards that matter most. Next in the hierarchy: Borrowers' eagerness (and willingness) to incur still more debt. Take mortgage equity withdrawal. With residential real estate prices falling, all but the most desperate (or irrational!) homeowners will be very reluctant to leverage themselves further to their depreciating assets.
For years--years when real wages remained relatively flat--mortgage equity withdrawal (MEW) was a driving force behind the unstoppable American consumer. Now, with MEW substantially diminished, and not likely to rebound in a meaningful way any time soon, consumers are more strapped than ever. On the margin, consumers have entered a period of balance-sheet-restoration.
Given this country's unholy levels of private debt (to say nothing of our public debt), the rebuilding of household balance sheets is great, great news. But it will cause short- or medium-term challenges. Welcome to the business cycle.
Matthew Goldstein and David Henry, "Tapped-Out Consumers," BusinessWeek, January 28, 2008
Courtney Schlisserman, "Case-Shiller Home Prices in U.S. Fall for 11th Month," Bloomberg, January 29, 2008