US Rate Cut Welcome, But...

Source : The Straits Times, Thu, Sep 20, 2007

THE United States Federal Reserve's policy-making Open Market Committee (FOMC) slashed short-term interest rates by a surprising 50 basis points. Global stock markets reacted deliriously, with the Dow Jones Industrial Average rising by 2.5 per cent on Tuesday. Happy days are here again? The sub-prime crisis is over? Fears of inflation have been laid to rest? A reading of the fine print of the FOMC's statement would suggest that the central bank has not altogether set aside its inflation concerns. It did not repeat its previous insistence that inflation was its 'predominant concern', but it did not say either that it was now worried most about the possibility of recession. Instead, it spoke of 'uncertainty' ahead.

Did it over-react to the uncertainty caused by the crisis in the sub-prime mortgage market? Many economists had warned that the Federal Reserve should not step in to make things easy for speculators. To do so would pose a moral hazard, they had argued, encouraging speculators to assume the central bank would always ride to the rescue. The FOMC obviously decided that the possibility of it encouraging the excesses that led to the sub-prime crisis paled in comparison to the possibility of that crisis triggering a downturn. Or to quote the words of former Fed chairman Alan Greenspan: 'The question (the FOMC) had to weigh was, 'Was punishing those (speculators) more important than doing something that (it) perceived to be in the greater good?'' - and it decided 'the greater good' was more important. Fed chairman Ben Bernanke and his fellow governors probably took note that the US lost jobs in August, the first time that this has happened in four years. They probably would have been struck too that housing foreclosures were 36 per cent higher in August than in July. As the FOMC's statement accompanying the rate cut put it, 'the tightening of credit conditions has the potential to intensify the housing correction and restrain economic growth more generally'.

Whether the rate cut will suffice to restore confidence will depend on developments in the credit markets. The chief problem the US economy faces now is not high interest rates, but liquidity. Investors spooked by the sub-prime crisis have been reluctant to take up mortgage-backed securities; banks, unable to sell their loans to the securities market, have been forced to carry them on their books; and hedge funds and private equity funds have found it difficult to borrow money. Cutting short-term interest rates will no doubt help businesses and consumers, but the sub-prime crisis will probably take some time to sort itself out.