Mal Practice

Mal Practice?

The Federal Open Market Committee (FOMC) should keep the federal funds rate at 3 percent.

While it is likely cuts in the federal funds rate may encourage growth in GDP from the lackadaisical rate of 2.2% in 2007, it is not certain. A rate cut would spur a brief growth period in the short run where wages are relatively sticky and the aggregate supply curve is flat, but there would then be a trade off. Doing so could raise inflationary expectations and store up problems for the future. Abruptly increasing the money supply just to stimulate a temporary economic boom is typically not advised, due to the fact that eliminating the increased inflationary expectations will be nearly impossible without producing a recession. This goes against the goals of the fed to foster “price stability” and “maximum employment” (Blinder, 1997). I say typically a bad idea because there are periods when the economy is hit by some unexpected external shock (subprime mortgage crisis), and it may be beneficial to offset the macroeconomic effects of the shock with (expansionary) monetary policy.

The problem with the subprime rate crises and the current expansionary policy (cutting the Fed. Funds rate) is that this “antidote” maybe the wrong prescription for the markets ailment (Credit Crunch). The subprime mortgage crisis was an abrupt rise in home foreclosures in late 2006 which became a global financial crisis during 2007 and continues to be a problem today. The crisis began with the bursting of the housing bubble, which led to high default rates on "subprime" and other adjustable rate mortgages (ARM) made to high-risk borrowers with lower incomes than "prime" borrowers. A long-term trend of rising house prices encouraged borrowers to take on mortgages, believing they would be able to refinance at more favorable terms later. However, once housing prices started to drop moderately in 2006-2007 refinancing became more difficult. Defaults and foreclosure activity increased dramatically as ARM interest rates reset higher. Nationally, the number of mortgage loans that entered some stage of foreclosure rose to 117,259 in February, up 68% from the same month a year earlier, according to Irvine, Calif., online foreclosure-data service RealtyTrac. (Reed, The Wall Street Journal Online)

The mortgage lenders that retained credit risk (the risk of payment default) were the first to be affected, as borrowers became unable or unwilling to make payments. Major banks and other financial institutions around the world reported substantial losses. Many mortgage lenders had passed the rights to the mortgage payments and related credit/default risks to third-party investors via mortgage-backed securities (MBS) and collateralized debt obligations (CDO). Corporate, individual and institutional investors holding MBS or CDO faced significant losses, as the value of the mortgage assets declined. Stock markets in many countries declined significantly.

The widespread distribution of credit risk and the unclear impact on financial institutions caused lenders to reduce lending activity or to make loans at higher interest rates. This latter activity by lenders and financial institutions was dubbed