Between a rock and a hard place

The Feds find themselves in the unenviable position of “being between a rock and a hard place.” Economists have been predicting a recession for some time now. In the last few months of 2007, the Feds took steps to keep this from happening by lowering the federal funds rate and discount rate. The series of cuts did spur spending and investing in the stock market (as is typical with a cut). So what is the initial outlook for 2008?

Goldman Sachs is one of the largest investment banks in the world, and they offer their financial advising services to wealthy families, large corporations and governments. Their 2008 forecast predicts a recession for 2008 along with a growing unemployment rate to reach 6.5% by 2009. Unemployment is currently at 5.0%.

Goldman is also forecasting the Fed will continue to slash the Fed Funds rate until it reaches 2.5% by the third quarter of this year in an effort to achieve a “soft landing” for the economy.

…Interestingly enough, a couple days after Goldman released their forecast, Bernanke said the Federal Reserve would take steps to help keep the country out of a recession and would cut rates to do it…

If Goldman continues to be right, it would mean the Fed Funds rate would be cut by another 1.75% from their present level of 4.25%. Keep in mind that with every rate cut the odds increase for a rise in inflation and the weakening of the U.S. Dollar. Sadly, this is happening. Inflation figures are up and the U.S. Dollar is near all time lows versus the Euro and the Pound.

With today’s news of poor retail sales in December and Citigroup taking a $10 billion loss, as much as Bernanke says he wants to fight inflation, the Feds may not have a choice. So, which do the Feds prefer, the rock (recession) or the hard place (inflation)? It seems the economy is – for now – forcing them to choose the hard place, inflation, and the Fed funding rate will continue to be cut to stimulate the economy.

What does this mean for interest rates? It is really too early to tell, but rate cuts cause inflation to rise. Rising inflation causes mortgage rates to go up. Whereas poor economic news (and we are seeing a lot of it lately) is actually good for rates, and mortgage rates go down.

So, who is going to win? For now, the bad economic news is winning out as rates are at their lowest levels since June 2005. However, if the Feds combat this through continued and significant rate cuts, at some point inflation figures will go up, which will make mortgage rates go up. It will be interesting to see how this plays out in the coming months.