PART OF THE CURE: Mr Gittler sees the Fed's move as a significant step towards restoring confidence to the credit markets. -- PHOTO: DEUTSCHE BANK
FORCEFUL. Gutsy. Unambiguous.
The United States Federal Reserve has delivered a powerful jolt to sickly financial markets by slashing the key federal funds interest rate by half a percentage point, double what most analysts were expecting.
This is strong medicine, considering that the last time the US Fed cut rates so drastically was in November 2002.
Investors showed their relief by sending stock markets skyrocketing worldwide yesterday.
So the Fed's action has already worked a dream on investor sentiment, if nothing else.
For one, it showed that America's central bank is not turning a blind eye to worsening financial conditions by keeping rates unchanged. Nor is it taking the ambiguous route by lowering rates by a timid quarter point.
But apart from knee-jerk euphoria, does this really mean that all is well for the global economy from now on?
For that matter, how exactly does an interest rate cut work?
'It is too early to tell if the Fed cut will work,' said United Overseas Bank economist Thomas Lam.
'But as a calculated gamble, this had better work,' he said.
Mr Lam argued that the Fed was so aggressive this time because it believed a single dramatic shock was better than a few small ones spread out. In other words, 'the Fed is hoping to do (a half point) at a go, and that's it'.
The aim of such shock therapy is no longer just to prevent the US housing slowdown from infecting the whole economy.
Rather, as the Fed highlighted in its accompanying statement, 'the tightening of credit conditions has the potential to intensify the housing correction and to restrain economic growth more generally'.
Put simply, the more pressing worry is a paralysis in credit markets.
The unfolding credit crunch, which has left banks so wary of risks that they would rather sit on their cash than lend, makes funds expensive or simply harder to come by.
Calling this a 'plumbing problem', Deutsche Bank chief Asia Strategist, Mr Marshall Gittler said: 'The Fed's move is a significant step towards restoring confidence to the credit markets and thereby buys time, which is what's needed to solve the plumbing problem.'
Monetary easing can work in several ways, and shoring up confidence is as crucial as any other objective.
It instantly signals to the world that the Fed is serious about stimulating the economy. In the current credit squeeze, that news in itself would boost market sentiment, and perhaps encourage cautious investors to lend again.
Apart from spurring confidence, lowering the official interest rate works via three channels, explained Mr Lam.
First, it increases the pool of cash that banks have to lend to each other.
Second, it reduces the borrowing costs for any loans which are tied to the fed funds rate, for example, prime rates. Lower interest rates for adjustable rate mortgages could serve to reduce defaults, Mr Gittler pointed out.
Third, just as costlier funds make investors think twice about buying riskier assets, cheaper funds have the opposite effect.
It might cause a reassessment of risk by investors, and lead to a return in the appetite for riskier instruments, such as emerging market bonds. However, these effects take time to work their way through the financial system, and it is difficult to gauge whether yesterday's rate cut would be enough.
'The Fed cut is not a panacea, but it is clearly part of the cure,' said Citigroup economist Chua Hak Bin. 'Another (quarter point) rate cut would be needed to restore financial conditions to normal,' he said, as the recent seizing up of credit markets was equivalent in impact to the Fed hiking rates by between a half and a three-quarter point.
Mr Lam added: 'But if by the next Fed meeting in October, data comes in better than expected, and if financial markets normalise, then the Fed has done an excellent job by springing this surprise cut.'
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