November 8th – Princeton economists like to joke about their ex-colleague Professor Ben Bernanke, now the Chairman of the Federal Reserve.  He decided, they say, to take a step down and leave the department in order to run the world.

Today, as Chairman Bernanke testified before Congress’ Joint Committee on Economic Policy, it was easy to tell that he certainly eschewed the easier of the two jobs.  After a powerfully negative opening speech by the committee’s chairman, Senator Schumer (D-NY), Bernanke had to be as coy as humanly possible in his testimony in order to avoid tipping his hand and letting the world know if the Federal Reserve intend to again lower its overnight rates when it next meets.

Having cut rates twice in the past month for a total reduction of three quarters of a percentage point – after enduring withering criticism for not cutting rates earlier – the Reserve Board hopes that the prior two cuts will provide enough economic stimulus to sufficiently ease the damage done to the economy by the subprime mortgage crisis.

Analysts doubt, however, that Bernanke will be able to resist pressure to reduce rates again later this month or in early January.  Their previous statement on the matter – which Bernanke partly repeated in his testimony today – made the argument that because the subprime woes seem to be mostly contained, further cuts are not necessitated.  In the ensuing days, however, Citibank announced the resignation of its

CEO, that it was writing off $11 billion in debt, and that ex-Secretary of the Treasury Paul Rubin would be made temporary CEO as the company shifts into crisis mode.

So, unless oil rises significantly past the $100 mark, it seems probable that the Fed will heed the turmoil in the financial industry and cut its overnight loan rates another .25 percentage points when next it meets.

Beyond the next month, however, what is the outlook for interest rates?  The question depends largely on the behavior of oil prices.  If they stay well above a hundred dollars a barrel – a price not too far removed from the cost of oil during the OPEC embargo – then Bernanke will at least have an excuse to not reduce rates further.

Even if the Fed keeps rates the same for the next year, interest rates on the loans people use to purchase homes will likely decrease slightly, as demand for mortgages continues to fall through the height of the subprime crisis – which the Fed Chairman doesn’t expect to abate until the beginning of 2009.  Mortgage applications fell 1.6% last week, and the rates for a 1-year mortgage remained below the critical 6% mark.

Unless the price of oil continues to significantly increase, already low interest rates on home loans will probably fall somewhat through 2008, though their decline is not expected to be especially large.

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