The Federal Reserve unexpectedly lowered its target Fed funds rate by a half point today — to 4.75 percent — in an effort to stave off a potential recession. This is the first time the Fed has cut short-term interest rates since June 2003, after raising the Fed funds rate 17 times between June 2004 and June 2006. The Fed had previously held this key interest rate steady at 5.25 percent over the past thirteen months.
The Fed said in its statement to the press that the "tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth."
In regards to today's rate cut, you should keep the following in mind: Although many investors think the economy and stock prices are quick to respond to interest rate cuts, historically, it takes at least six months before interest rate cuts take effect. Sometimes, it takes much longer.
For example, after the Fed began lowering short-term interest rates in July 1981 the economy did a head fake: Economic growth temporarily rose for two months but then fell back into a recession until March 1983. In addition, stock prices fell 11 percent in the six months following the initial interest rate cut.
When stock prices crashed in 2000 and the economy entered its worst recession since the early 1980s, the Fed needed to cut interest rates ten times — from 6.50 percent to 1.75 percent — before the economy began to grow again in December 2001.
And, when the economy finally returned to its historic growth rate of 3.5 percent in 2003, it was mainly due to several other factors that were unrelated to the Fed's monetary policy, including:
(1) Inflation-adjusted interest rates actually fell below zero in August 2002 and remained below zero through April 2005.
(2) Major revisions were made to the U.S. tax system in 2003 for the first time since 1986 — the top individual tax rate was cut to 35 percent from 39.6 percent, the capital gains tax was lowered to 15 percent from 20 percent, and taxes on dividends were cut to 15 percent from 38.6 percent.
(3) Significant fiscal stimulus had a major impact on the economy during this period, as a Federal budget surplus of $236 billion was completely exhausted via spending on the war in Iraq.
So, I'm siding with legendary investor Jim Rogers who said in an interview earlier today, "the Fed is irrelevant" and "a temporary bandage … is not going to solve our problem". Rogers went on to say, "I think we'll have more problems in the stock market this year and 2008".
In other words, the Fed will likely be unable to prevent a recession, today's rate cut will merely serve to increase inflationary pressures, and stock prices are likely headed lower over the coming months.
But, not to worry, because as I've mentioned over the past several weeks, I'm finding plenty of ETFs that make it possible for you to profit from a slowing economy and rising inflation over the coming months. And, you can now take advantage of my research by trying our new investment letter — The ETF Strategist — which focuses on this very topic.
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