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Wednesday, July 9, 2008

* Interest Rates: Things Are Not Always As They Have Been

Each month the Wealth, Money & Life Network chooses a topic as that month's theme. Since our members are a diverse group, the selected topic is usually broad, allowing each of us an opportunity to address it from our perspective. This month, Interest Rates was selected as our topic.

Historically, stock investors cheered when the Fed lowered interest rates. This nearly always would lead to a run up in the stock market. Lately, the Fed has been firing blanks.


First, some background. Fed above refers to the U.S. Federal Reserve Bank and the interest rate is the federal funds rate. This rate is what the Federal Reserve banks charge member banks to borrow money. In the past, the Fed would use this rate to attempt to control inflation and direct the economy. When the economy was heating up and inflation was a threat, the Fed would raise rates to slow the flow of money to businesses, which would in-turn slow the economy and hopefully head off inflation. Conversely, when the economy slowed too much and inflation was no longer a threat, the Fed would lower rates to increase the money supply and stimulate the economy.

So after several rate cuts, why isn't the U.S. economy responding? Things are not always as they have been. There are many factors driving the current state of the U.S. economy, but I will focus on the two I consider the most influential.

I. Energy Costs
Even with a slowing economy the U.S. is experiencing a degree of inflation. This is driven by the pass-through effect of energy costs. As the price of diesel fuel goes up, so does the cost of transporting food, electronics, equipment, industrial goods and everything else that is sold in a place different than where it was manufactured. These costs are ultimately passed to consumer. While this has been bad for many business and the economy, some companies have benefited enormously. Consider my recent stock analysis of Exxon Mobil Corp. (XOM). Their enormous profits have pushed the company to a point I consider it grossly overvalued. The same could be said for Chevron Corp. (CVX).

II. Financial Markets
Instability in the financial markets has contributed to the current economic condition. Even though money is relatively cheap, there is not a rush to lend or borrow. The sub-prime collapse has caused fear and unrest. Even with low interest rates, banks are hesitant to loan money given recent, and very public, write-downs they have had to take. As a former shareholder of Citi Group Inc. (C), I watched as C went through a financial melt-down, took out a payday loan before slashing their dividend. Now the spotlight is on Bank of America (BAC). Will it follow the same path as C?

From a consumer's standpoint, each of the above has caused a great deal of concern. When people are concerned about losing their job, they aren't as apt to spend, further dragging the economy down. With all this fear and uncertainty, it is a great time to be a dividend investor!


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