Recently the US Federal Reserve cut interest rates by 75 basis points from 4.25 per cent to 3.50 per cent on January 22 and a further 50 basis points to 3 per cent on January 30.This was the Fed's response to a possible recession in the US and has completely surprised financial gurus all over the world.
It was a totally unexpected and also an unprecedented step.This major cut in the interest rates by the Fed has in it,a high potential to dynamite the US dollar, the US economy and, by natural extension, the global financial market and even the world economy.
What really surprised many analysts is the fact that the US Fed's capitulation to reduce interest rates,in the pretext of tackling possible US recession can very well well turn out to be its death bed. Plainly speaking,the US continues to face the a risk of an economic recession even after this rate cut as it did before.
No economist ever agrees with another one in such matters.If you have a meeting of three economists,you almost invariably end up having five different opinions!. Nevertheless, almost all economic gurus and financial wizards,the world over,are nearly united in their opinion that the situation of the US economy is extremely serious now.In fact,several experts are of the opinion that the US economy;which is practically the driving force of world economic and financial growth;is truly well into a recession.
What is now being considered as certain proof of a recession in the US is that the US Fed cut interest rates on three different occasions in the second half of 2007 totaling to 100 basis points, prior to the latest cut of 125 basis points in January 2008. These are very alarming signals; coming in such a short span of time
Some relief for (sub-prime) borrowers?
Presumably this rate cut is planned to reduce the serious housing recession in the US since 1991 and to ease pressure on the economy of the nation. The situation is so crucial that some US lawmakers had called for cheaper borrowing costs for the benefit of the average Americans.
And this cut is aimed at providing some relief to the stakeholders -both borrowers and lenders -who were party to this abundance of a credit bonanza for the past several years. It should be be pointed out here that it is the availability of huge amounts of credit in the US which really drove the engine of global economic growth as mentioned earlier.
And it is not a problem that concerns only the sub-prime borrowers, as the common man believes.As many credit card,car and other types of consumer loans have also begun to turn bad,the US financial sector is facing a crisis of a hitherto unknown and serious magnitude.
By extension, its effects on the global financial markets are bound to hurt.
As a consequence,with several banks and even major financial institutions facing prospects of going burst,the Fed had no other option but to cut interest rates.For,if it hadn't effected done that,it might have led to the formation of a severe crisis within the US financial sector over the next few months and might have also led to the collapse of several financial institutions.
But will the rate cut solve the real problem?
By cutting interest rates the US Fed probably expects that consumption will take a boost, the magnitude of mortgage payments will be lowered, and in that process drive a recovery in the economy.However many top economists - including Noble Laureate Joseph Stiglitz -have pointed that this will be an exercise in futility.They say that this cut in interest rates will have hardly any impact on the overall financial and/or economic scenario.
According to these economists,it is a case of too little being done rather too late -somewhat similar to applying a little pain killer when chemotherapy was needed to treat the cancer.
Even as interest rate cuts are executed,experts tend to believe that US Fed chairman Ben Bernanke may be open to the charge of creating a 'moral hazard.' After all, the act of the Fed is benefiting all those who were party to unreasonable and reckless borrowings and lending.And who did not evaluate the creditworthiness of the beneficiaries.
As the US is regularly lowering its interest rates,many world economists are worried that, that the US would find global capital is moving away to other countries which offer higher rates of interest.This could lead to appreciation of currencies across other countries of the world and a reduction in the value of the US dollar. As the dollar devalues against other currencies, goods from other countries would become costlier in the US and that would in turn lead to inflationary tendencies within the US.
"According Allan Meltzer, a Fed historian, the Fed "put all of its chips on the prospect of a possible recession, and very little on the possibility of inflation." And should the US be visited by a bout of inflation, as predicted, the Fed would have no other option but to once again increase interest rates. And that could be an unmitigated disaster".
What must invariably worry US economists is the fact that several years of continuous imports of 'cheap' goods,aimed at controlling domestic inflation,resulted in neglecting the growth and competitiveness of the domestic manufacturing sector,here in the US. It should be noted that such a model also suited developing nations as it provided manufactured products at lower costs to them.But one day or other,even good times have to come to an end,right?
In addition this also makes the task of establishing and developing a competitive domestic manufacturing base within the US in the immediate future,yet another exercise in futility. If there is only a weak-manufacturing base in the US and if there is growing dependence on imports to meet domestic demand,it is quite possible that any further devaluation of the dollar could drive further inflation in the US. And that could be a launching pad for higher interest rates.
However can all these lead to a probable collapse of the US dollar?
Note that inflation within the US is not the only concern of global economists. What compounds the entire economic and financial matrix is that the US had to depend on global capital flows of approximately $1 Trillion( $ 1000 million)last year to sustain itself on the economic front.With global inflation rising uncontrollably and central bankers of other countries having exhausted almost all other policy options to deal with inflation,interest rates are already at high levels,across several countries and continents.
Therefore and naturally enough,the central banks of other economies are in no mood to cut interest rates in unison with the Fed of the US.
It is now thought by many economists that this steep interest rate cut by the Fed would result in currency rate readjustments.
It will not be big wonder,therefore,if the the dollar is going downstream against the other currencies.
In such a scenario,as financial markets realize the inherent risks arising out of interest rate cuts imposed by the US Fed,they will certainly witness corrections and readjustments, which is behind the drop in stocks and shared that we have recently seen across the globe.
Global financial markets are already( by Jan 2008 itself)feeling exhausted within days of the Fed announcing the moves.How can any body compare or analyze the risks, returns and rewards on investments when the principal itself is in jitters? This is one question that seems to have come back to haunt the global financial markets in 2008.
For all the above reasons,the interest rate cuts need not work and Fed's ideas could well be doomed to fail. And that is the most crucial issue - the US economy would have collapsed had the Fed not cut the interest rates and as it cuts the interest rates it could drive down the dollar values and may lead to its ultimate collapse!.
There is perhaps no need to point out that the real beneficiaries of the rate cut,are the stock markets and not the US economy as a whole.
Therefore what was the compulsion for the Fed to take this gamble of a rate cut? Why protecting the stock markets became the most vexing issue for them? Is the stock market more precious than the dollar? Is helping and bailing out the ridiculously reckless lenders and borrowers more important than controlling inflation US?
These are the real critical questions and the answers to such and similar questions may well determine the fate of the global economy in the next few months of 2008.
Learn more about this author, Madhusoodanan.K.P..
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