Dave Mahorney
Sandy Lenchner
Econ 202
December 1, 2007

Wall Street Journal Articles
Article #1
Lookahead: Gimme Gimme Gimme

By ROB CURRAN, DANIELLE LEGRAND and DEBORAH LYNN BLUMBERG
December 8, 2007 2:16 p.m.

Like a spoiled child awaiting holiday gifts, the stock market is stamping its proverbial foot and saying: “I want a rate cut, or else.”The combination of slowing jobs growth, somewhat weakened retail sales, and continued credit and housing market distress, has investors clamoring for more assistance from the Federal Reserve.And — after this week’s rally and September’s indulgent 50-basis point move — the market may even turn its nose up at a 25-basis point cut Tuesday when Fed policy makers meet.

The Fed has lowered its target rate now by 75 basis points since September to 4.50%. Hopes for a very aggressive ease next week were reduced Friday following a modest gain in the November employment report.But some are still sticking to their call for a 50-basis-point ease to help markets weather the storm set off by subprime mortgage bets gone bad.Such a move would be “more proactive,” said John Miller, managing director at Nuveen Investments in Chicago, putting “the Fed ahead of the curve.” Despite the fact that the jobs market looks OK, the stress that bank balance sheets are under, and the concerns in the banking industry continue to grow,” he said. A 50-basis-point cut would be targeted toward the banking, lending and mortgage finance sectors and have little to do with job growth specifically, he noted.Tony Crescenzi, chief bond market strategist at Miller Tabak & Co., pointed to the climbing rate on 30-day asset-backed commercial paper as a top reason to expect a more aggressive move from the Fed. The rate on 30-day ABCP is now 157 basis points over fed funds, much higher than the 110-basis-point spread seen in August, in the first round of money market troubles.The Fed “has been unusually quiet amid these worsening conditions and the well-advertised problem related to year-end funding pressures,” Mr. Crescenzi said, leading him to believe a bigger cut may be in the cards. Such a hefty ease, however, would also likely take its toll on longer-term Treasury securities, pushing their yields higher, as fears about inflation pressures would almost surely intensify. Inflation worries were already evident on Friday, as losses in longer-term Treasuries picked up speed.Investors next week will also be eager to see what change, if any, the Fed makes to its discount rate, its primary emergency lending tool, where banks can borrow money directly from the central bank.Speculation is growing among market participants about a possible aggressive cut and a narrowing — or even an elimination — of the gap between that rate and the fed funds target rate. Such a move would encourage more banks to tap the discount window, helping to ease the liquidity problems taking their toll on markets. A large discount-rate cut would also likely placate any policy-makers who are more focused on inflation pressures and who aren’t totally sold on another cut in the fed funds rate. My surmise:
The Fed is predicted to lower the Fed target rate a quarter to half point and the discount-rate is predicted to be cut a half point. The fed fund target rate is the interest rate for inter-bank loans. Usually when this is lowered there is an immediate increase in bank to bank lending of excess reserves. This is followed by a spike in interest rates between banks as the demand for excess reserves increases. However with a drop in the discount-rate there may prove to be a way around the initial inflationary pressure. The discount-rate is applied to reserves borrowed directly from the federal bank. The rates would be 4.25% Fed Target and 4.5% discount, thus providing banks with incentive to borrow from them. There is a stigma of desperation with borrowing from fed, but with rates this low it only makes sense. Thus, the Fed will provide banks with the liquidity that is desperately needed as a result of losses in subprime paper. This relates to the class in our recent discussion on the Fed’s distribution of excess reserves. It details two different forms for injecting reserves into the banking system. Bank to Bank lending through the target rate and Fed direct to Bank through the discount window are both means of acquiring excess reserves. Bank to bank loans would be in competition with discount window loans, thus keeping the overnight rates fairly close to the target rate. Both forms will increase the monetary base by increasing excess reserves. The question is will the banking system utilize that money for loans, thus increasing the money supply (M1), or will they hold on to it for liquidity reasons. The other factor in this is businesses and consumers. Right now credit is cheap and essentially this would spurn an economic expansion (increase in M1 > money stock has decreased thus increasing C and Ip due to weak dollar and increased exports > increase in AD > increase in AS > increase in equilibrium GDP). This would be the perfect scenario right? So is the classical economic theory. However, with the wounds of the subprime market still fresh, banks have increasingly tightened credit criteria and it will be up to A-paper borrowers, credit worthy businesses and the rich to increase consumption. Good luck!! We all know the real consumers are lower to middle class income earners. Most of who are struggling to keep above the ever rising debt load. Some of which was acquired by shady lending practices that started out this subprime nightmare. There needs to be an enlightening of the masses towards debt and income management and a demand for a sense of urgency towards savings. It would be nice to see a government policy or corporate sponsored “matching” program that would assist the low to average income family of 10-60K/yr. households. Perhaps a “50/50” savings cards issued by Visa, MasterCard, AE or any credit-card company would work. This could provide an average of 5 % annual return on savings vesting 25% per 7 years for 100% vesting in 30 years (2 years of no contributions). Credit companies would match savings thus doubling their liquidity to which they could utilize on transactions to increase revenue. The interest paid to the consumer could be written off in taxes (5%/yr.).This would be contingent on completion of a money management class and monthly debt counseling. I need to stop this rant right here and climb off my soap box. Now back to the Fed and their ideal reaction to a rate cut. First the initial cut to rates incurs through the creation of excess reserves by purchasing of government backed securities. They flood the open market with these reserves to the point that the Fed fund rate drops. This eventually leaks into longer term interest rates thus creating an opportunity cost of holding or acquiring liquidity vs. interest based investments. This is represented in the money stock and supply graph as a shift in the money supply due to banks and the public taking advantage of this opportunity cost, thus increasing M1. Next we see an increase in loans as a result of demand for liquidity and the low interest rates. This leads to an increase in PAE as C and Ip increase. Also exports rise as the dollar decreases in value and foreign currency has increased its purchasing power. These factors cause a positive shift in AD soon followed by an increase in AS, thus increasing GDP. This would be the ideal result of the Fed’s expansionary monetary policy. There is an increase in GDP and no inflationary pressure on prices. If only things worked as easy as they do in Macroecomics ECON 202.