LIBOR - The London Interbank Offered Rate

The London Interbank Offered Rate, also known as the LIBOR for short, is a daily reference rate at which banks offer to lend unsecured funds to other banks - specifically on London's money market. The LIBOR, however, is used all over the world as the basis for many securities that return a variable rate of return. Why is all this important or interesting? Well, the way it is calculated has come under attack in recent years and that model may very well be changing as a result.

The non-governmental British Bankers Association (BBA) that sets the LIBOR does so by first collecting reports from its member banks. These banks report what their costs of borrowing are to the association which are then figured into an average for use by all banks as their reference rate - the basis on which they offer funds to business and individuals for anything from mortgages to company lines of credit. In recent years, however, there has been mounting speculation that the member banks reporting their borrowing costs have been fibbing - under-reporting so as to keep their own borrowing costs lower.

With the slowing world economy and continued concerns over credit availability for many financial institutions - not exclusively those in the United States - interest rates are expected to begin to rise. Just as this means our own cost of borrowing on car and school loans will begin to tick upward, the big banks are concerned that their own costs will rise. Having issued much of their recent loans at the presiding low rates and many still saddled with quickly depreciating assets, this does not paint a rosy picture for banks as an industry. Of course, it's hard to see how this is any justification for manipulating the system for their own benefit.

As with CDOs, default swaps and mortgage-back securities, it's important for any investor to understand exactly what it is that they're buying when they invest their savings. The LIBOR is one of those elements that many of us likely take for granted, but this too should be a factor in our investment decisions. Understanding that the LIBOR is a manufactured entity should spur our own questioning of its validity and interest in alternatives - and there are many. The Fed Funds Rate, the Treasury Bills rate (for the relevant maturity, of course) or even your own banks prime rate. Consider the alternatives; talk with your bank managers and choose a reference rate with which you feel comfortable will provide you with an accurate representation of the cost paid by banks - the cost that they will the pass along to you.

Never mind a cut to 2%, how about a hike to 2.50%

On Wednesday this week, the Federal Reserve, headed by Ben Bernanke, will meet to decide the fate of interest rates for the next six weeks. The rate currently sits at 2.25% - 3% lower than it was just nine-months ago. Mr. Bernanke and the Fed have been very aggressive with their cuts to help keep the economy out of a recession. Today, however, with most people agreeing that the economy is already in a recession, what should the Fed do next? More importantly, with inflation concerns higher than ever, a further attempt by the Fed to keep this recession as mild as possible could come at an incredible cost a year from now.

The rising cost of fuel and, more recently, commodity prices have made living expenses rise for the average consumer. The Fed hasn't helped either. The lower interest rates have caused the American dollar to sink against the Euro and other currencies - as much as 7%! This too has caused import prices more expensive and driven-up costs for consumers. All these rising prices mean one thing: inflationary pressures.

Today's economy is being compared to that of the late 70s and early 80s more than ever. A lot of people are beginning to foresee high inflation. The only thing that has helped the Fed, and the economy, is the general believe by the American people that the Fed is doing (and will continue to do) all that it can to keep inflation under control. This belief may quickly vanish, however, if the Fed doesn't begin to deliver on those expectations. Why care?

If inflation does start to creep-up like a lot of people believe that it will, then it will need to eventually be brought under control by the Federal Reserve. In the 80s, Paul Volcker, then Fed Chairman, pushed interest rates up to the high-teens in order to bring inflation back from its double-digit levels. This, of course, sent the economy into a VERY deep recession. If Mr. Bernanke isn't careful, his successor will need to do the same thing because he'll certainly be out of a job.

As speculation mounts over whether the Fed's meeting will result in a quarter percentage point cut to 2% or stay-the-course at 2.25%, maybe the Fed should rather be considering a quarter-point hike!

Is there really a difference between 2.25% and 2.00%

Ok, so I studied finance and I know that there is a 25-basis-point difference, but I think that you and I both know that that's not what I meant.

The Fed (the U.S. Federal Reserve Bank), via the open market operations, helps to manage the swings in the business cycle by monitoring various economic indicators and pulling various levers to flatten-out the bumps. One of these levers, the most important one actually, is the interest rate (the Fed Funds Rate, to be precise).

When the Fed reduces the interest rate, it makes money cheaper - it makes borrowing money less expensive because those who do borrow, pay less interest. You have to ask yourself, however, whether a 0.25% further reduction in the interest rate will stimulate those who have been holding-off on an investment decision (like buying a home or expanding business operations) to suddenly make the leap. The answer is likely no.

The Fed's actions are likely less important that the reasons for its actions. People watch the Fed to learn of what top economic minds think the economy will do next (or what it's doing now). With almost 300-basis-points down in the last 9-months, I think that we all can accept that the Fed and all those economic brains think that the economy needs help. We got the message, trust me. Sending the rate lower yet will not drive-home that message any further; moreover, it could cause problems for the Fed in the medium term should it really need to pull on that lever harder, later. It's going to be interesting to see what the Fed chooses to do; it will be more interesting to see if the markets react at all to whatever it is that they do choose to do!