Fed in or fade out

Indian Express, 21 September 2007

Stock markets all over the world have responded exuberantly to an interest rate cut by the US Federal Reserve Bank. In India too, markets shot up and the BSE Sensex crossed 16,000 making front page news. Stock 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. The connundrum here is that the Fed decision to cut interest rates is saying exactly the opposite. An interest rate cut by the US Fed suggests that the Fed is worried that there may be financial crisis and a 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 of the more cautious 25 basis points that was expected. This indicates that the Fed believes that the situation is worse than what most people are thinking. Stock markets shooting up on the Fed decision suggests that markets believe that the Fed wants to bail out financial markets and that its interevention will be effective.

India'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 one day gains. The story of the rise in Indian markets on 19th September does not lie in the FII buying Indian stocks. The story lies in what is happening in the US markets and how we are linked to the world economy. India's fundamentals today move with the world economy.

It is expected that in the next few months about 2.2 million home owners in the US will default on their home loans. They will lose their homes. Banks will repossess these houses and sell them off putting further downward pressure on home 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 employment declined for the first time in four years. A fall in housing prices has a direct wealth effect as house-owners spend less on consumption. Consumption consists of 72 percent of US demand and when consumption slows down , the risk of a recession is seen to be high. The fate 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 `moral hazard' problem. If financial firms know that they will be rescued when they take high risk and things go wrong, this will encourage them 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 have been fearing that the risk of creating moral hazard may be the reason why the US Fed may not cut rates. The Fed rate cut suggests that the Fed is not taking such a strict position on the moral hazard issue. But the Fed cannot affford 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 today's problems and give less importance to possible problems in the future.

The second issue is the risk of inflation. The US Fed is expected to look at growth and inflation in the US. However, in the last three decades it has a history of a focus on keeping inflation low. Unlike the Bank of England the US Fed is not, by law, an explicitly inflation targeting central bank. It was Paul Volker and Alan Greenspan as Chairmen of the Fed who made this reputation. Managing inflationary expectations requires a Central Bank to have a reputation of being committed to low inflation. Signals from the Fed upto two months ago were that the Fed 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 Fed'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.

But the market could be overestimating the effectiveness of monetary policy. In 1998 when there was a liquidity crises related to LTCM the Fed stepped in and resovled 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 with 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 'global imbalances' 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 did in the past. As stock markets see the story unfold there may be a lot of volatility ahead.

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