The Federal Reserve and other central banks around the world cut interest rates this morning for reasons that are obvious to everyone. Normally, we’d criticize the cut, given the sea of liquidity already flowing from the world’s central banks. But these are not normal times, nor is it clear when normality, or something approximating it will return.
One indication of the abnormality is the rapidly fading threat of inflation, at least for the short term. With the credit crisis becoming materially worse over the past month, the idea of generally higher prices is on holiday until further notice. Disinflation if not deflation is the bigger risk for the time being, which gives the Fed and its counterparts around the world more room to drop rates. (The Fed’s cut was 50 basis points, which brings the Fed funds target down to 1.5%.) But while the evaporation of inflation risk provides some monetary breathing room, it’s also a sign of trouble in the global economy. There are several ways to mute inflationary pressures, but what we’re experiencing now is the worst of all possible ways to achieve that otherwise sound goal.
The immediate question is how much help will a rate cut bring to the frozen credit markets? The pressing goal is convincing financial institutions to lend. Today’s rate cut will help, as will the various efforts announced by the Fed in recent weeks. But the prospect of a quick turnaround in lending is dim, at least for the moment. Confidence has been shaken in the belief that loans will be repaid in a timely manner, if at all. Repairing that battered sentiment will take time, and a 1/2-point rate cut, while helpful and warranted, is only a small part of the solution.

A critical issue is that it’s still not clear how the ongoing fallout in real estate will unfold. A big part of the problem is that an uncomfortably high share of residential mortgages are underwater—equity below the mortgage balance. The Wall Street Journal today reports that 16% of U.S. homeowners are underwater, based on data from Economy.com.
If you owe $300,000 on a house that’s worth $250,000, that’s going to influence most if not all of your financial decisions until the situation is resolved. It doesn’t help that the home value will probably fall further in the coming months if not years. The mortgage balance, alas, remains unchanged. That means cutting back on non-essential shopping, which reverberates in an economy that’s heavily dependent on consumer spending.
For some, the decision to simply walk away from their house weighs heavily. In that case, banks are saddled with more non-performing loans. Many homeowners will try and muddle through, although that gets harder if the labor market continues to deteriorate, which seems likely in the months ahead.
Ultimately, the solution to the housing crisis is lower prices and refinancing mortgages. But with credit markets frozen, securing new loans is tough. Clearly, all of this is going to bring a fair amount of financial pain on homeowners over and above what they’ve already endured. The government will undoubtedly step in various capacities to alleviate the financial suffering. Even so, the unwinding of the housing bubble isn’t over. We’re guessing that we’ll be well into 2009 at the earliest before signs of a bottom appear. Even then, the prospect of rebound in housing is several years away at least.
The Federal Reserve and the government can and will do much to help ease the distress, starting with efforts to keep the financial system from imploding completely. For what it’s worth, we’re confident that the government will succeed in keeping the financial apocalypse at bay. But repairing sentiment in the private sector is a different challenge, and one that will take time and the realization that prices of houses and other assets must fall to reflect the new supply/demand equation.
So, yes, today’s rate cuts will help, but only in terms of keeping the financial sickness from becoming worse. In fact, as we’ll be discussing semi-regularly going forward, the broader economic implications of the financial crisis have only started to hit Main Street.