Why Interest Rate Drops May NOT Be a Good Thing

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In a recent post on our forums, one of our members noted that she was hoping for a major drop in [tag]interest rates[/tag] from the [tag]Federal Reserve[/tag]. Richard Warren, one of our resident bloggers and real estate geniuses had a great bit of insight on the situation that I thought merited sharing:

Don’t be so quick to hope for lower rates. A simple law of physics states: Every action has an equal and opposite reaction. Lower interest rates from [tag]the Fed[/tag] will lead to lower rates on investor [tag]savings[/tag]. It will also cause an already weakened dollar to fall even further. This, in turn, will cause the cost of imported goods to rise. The major import is oil. After the last rate cut the price of oil hit the $100/ barrel mark. How much do you want to pay for gas? Lower [tag]short-term rates[/tag] will lead to higher inflation. This will cause long-term interest rates to rise taking mortgage rates with it.

The Fed has to play a very dangerous game with interest rates. It is a balancing act. The primary purpose of the Federal Reserve is to provide liquidity to the markets, everything else is secondary to that. If they stray too far from that purpose very bad things can occur.

Any thoughts on this one?

About Author

Joshua Dorkin

Joshua Dorkin (@jrdorkin, Google+) founded BiggerPockets.com when he saw a need for free, trustworthy information about real estate investing online. Over the past 12 years, Josh has grown the site from self-funded hobby to full-time job and passion. Today, BiggerPockets brings together over 600,000 members, housing the world’s largest library of real estate content, iTunes’ #1 real estate podcast, and an array of analysis tools, all geared toward helping users succeed.

3 Comments

  1. Personally, I feel the Fed is too involved with the housing industry and that is why we got to be where we are at today. I think that “providing liquidity” to the housing market has created artificial inflation, which is why we have experienced a ‘burst’.

    I do agree that lowering interest rates may not be the best approach to stimulate the economy, and that doing so will likely have negative repercussions.

    Here’s an idea… How about giving all U.S. tax payers a check for $100 that must be spent within 30 days of its issuance. This way the liquidity that the Fed creates will be in the form of real cash and people must spend it and not save it (because it expires), which would immediately stimulate the economy.

    What do you think about that??

  2. Bernard Savage on

    Look if you have a significant amount of money in savings you really shouldn’t you will never keep ahead of inflation that way! The Banks make big money on your savings accounts! Be little aggressive at least get a money market account! My Financial Planner Melanie Dean of Dean Financial in Nashville knows of some excellent strategies that will even make you money in this current economic environment car her 615-783-1702 she the best! Your need $100k in liquid assets! Tell her Bernard sent you!

  3. 1. In response to Mr. Jacobsen, perhaps the problem with the Fed was that it was not engaged in its regulatory role in the mortgage industry. By not demanding responsible behavior on the part of mortgage lenders and borrowers, people who expected a continual rise in housing prices were liable to get themselves into trouble – at least the last ones holding the “bag” would. Importantly, because we have not demanded accountability from the asset backed securities industry, the ratings agencies, and the bond insurers, we are sure to see future repeats of recent events. When a few can escape with their $billions in tact, the incentive for malfeasance continues.
    2. The housing market bubble was not strictly a creature of Fed policy. Perhaps the easy money policy of the late Greenspan era was a contributing factor, but there is a lot of literature out there that indicates that it would be hard to let the air out of the bubble in a nice and easy way. Sadly, because people and investors often engage in herding behavior, bubbles will be an constant part of our system.
    3. I think that Mr. Warren oversimplifies his analysis. Yes, excessive cutting of interest rates could stimulate inflation due to rising prices of imports. However, if consumption and investment are declining, these cuts are likely to simply to offset the deflationary pressures that could be flowing through the economy. I also wouldn’t say that the Fed is “playing a game.” Good policy requires responsible use of the tools available to them, and I think it’s clear that Bernanke has maintained a careful, even conservative, stance towards rate cuts. It’s all just speculation at this point. Perhaps the thing to say is that we really don’t want rates to go either way in the long run. That is, if rates are going up, it usually means that the economy might be heating up, and if they are going down, its cooling. As Goldilocks might say, it sure would be nice to get the oatmeal, “just right.”

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