Fed in or fade out

Brokers are upbeat about US8217;s interest rate cut. Economists are not. Why? And who8217;s right?

Stock markets all over the world have responded exuberantly to an interest rate cut by the US Federal Reserve. In India, the BSE Sensex crossed the 16,000 mark. The markets appear to be saying that despite all the bad news on the housing market in recent months, now all will be well with financial markets and the world economy. However, the Fed decision to cut interest rates is saying exactly the opposite. An interest rate cut by the Fed suggests worries about a financial crisis and recession. Thus, despite the risk of inflation going up, it has decided to take this step. The rate cut, at 50 basis points, was double the more cautious 25 basis points that was expected. This indicates that the Fed believes that the situation is worse than what most appear to think. And the fact that stock market indices shot up on the Fed decision suggests that markets believe the Fed wants to bail out financial markets and that its intervention will be effective.

India8217;s integration with global markets has been increasingly evident in recent developments. Stock markets in India moved down sharply when the sub-prime crisis hit US market. Now when the Fed cut rates, stock markets in India made their biggest single-day gain. The story of the rise in Indian markets on September 19 does not lie in the FIIs buying Indian stocks. The story is what is happening in the US markets and how we are linked to the world economy. India8217;s fundamentals today move with the world economy.

It is expected that in the next few months about 2.2 million American home owners will default on their home loans. They will lose their homes. Banks will repossess these houses and sell them putting further downward pressure on house prices. The construction industry has seen a slowdown in recent quarters. GDP growth in the US has slowed down. The latest US payroll data on employment shows that it declined for the first time in four years. A fall in house prices has a direct wealth effect as house-owners spend less on consumption. Consumption consists of 72 per cent of US demand and when consumption slows down, the risk of a recession is seen to be high. The fates of China, which supplies goods to the US, and India, which supplies services, are linked to the US slowdown. So is the fate of East Asian economies that export parts to China to assemble, as well as African and Asian nations that export commodities.

If things look so bad to the macroeconomist, what could be the reasons for the euphoric market response to the rate cut? The first is the moral hazard issue. For some time as news about the sub-prime market crisis has come in, it has been feared that many financial firms are facing the threat of bankruptcy. This has prompted calls for help from the financial sector. The difficulty in rescuing financial firms is that it results in a 8220;moral hazard8221; problem. If financial firms know that they will be rescued when they take high risk and things go wrong, they could be encouraged to be complacent about risk.

Cutting interest rates means increasing liquidity, easing the credit crunch in the US economy and helping some of these firms to remain in business. Markets had been fearing that the risk of creating a moral hazard could deter the Fed from cutting rates. The Fed rate cut suggests that it is not taking such a strict position on the moral hazard issue. But the Fed cannot afford to punish the guilty at this time because the risk of a recession in the US is too big. The moral hazard issue has to take a back seat because it needs to address today8217;s problems and give less importance to possible problems in the future.

The second issue is the risk of inflation. The Fed is expected to look at growth and inflation in the US. However, in the last three decades it has focused on keeping inflation low. Unlike the Bank of England, the US Fed is not, by law, an explicitly inflation targeting central bank. Paul Volcker and Alan Greenspan as chairmen of the Fed were responsible for creating this reputation. Managing inflationary expectations requires a central bank to have a reputation of being committed to low inflation.

Signals from the Fed up to two months ago were that it would remain hawkish on inflation. This meant that even though there was risk of slower growth, as long as the risk of inflation was not down, interest rates would not be cut. The decision to cut rates indicates that Ben Bernanke is seriously worried about growth, to the extent the he will put the Fed8217;s reputation of being committed to inflation at risk. This has given markets reasons to believe that the risk of recession may now be lower since the Fed will give greater weight to growth.

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But the market could be overestimating the effectiveness of monetary policy. In 1998, when there was a liquidity crisis related to the LTCM, the Fed stepped in and resolved the problem. In 2001, when 9/11 posed the risk of recession, expansionary fiscal and monetary policies were adopted. In time the US economy responded. But the credit cannot be given to monetary policy alone. The difficulty in the present situation is that it is far more complicated. Housing and consumer durables are already in trouble. It is not clear what the extent of the losses of financial firms might be. Would the correction need a correction of 8216;global imbalances8217; of the US fiscal and current account deficits which have long been a source of concern for macroeconomists? This time the Fed may not be able to solve the problem as quickly and easily as it has in the past. As stock markets see the story unfold, there may be a lot of volatility ahead.

The writer is a senior fellow at the National Institute of Public Finance and Policy, New Delhi