As
the Fed governors trooped into their meeting yesterday, which was not far from
midnight in India, fears were growing in the markets that they were going to vote
for stable rates. Some investors felt the Fed would not gift a rate cut this time,
if only to remind them that it cannot be expected to meet all their wishes. If
central banks keep behaving the way the markets expect them to, then complacency
will set in and risk appetite will grow. Besides, if there are no surprise elements,
most monetary policy tools will turn blunt and will fail to deliver the outcomes
expected by central banks. In such a scenario, they also run the risk of ''falling
behind the curve'' - the worst indictment for any central bank. The
Fed had to consider conflicting sets of economic data and persisting fears of
a re-run of the credit market scare. On the one hand, the US housing sector is
slumping into even deeper depths every month and there is no end in sight. But
most other sectors of the economy are holding up surprisingly well and the anticipated
weakness in labour markets is yet to materialise. Exports
from the US continue to benefit from the cheaper dollar. Though corporate profitability
growth has declined to the lowest in recent years, mostly because of the multi-billion
dollar losses in credit markets, US companies with large overseas operations -
and there are many - are doing very well. The
weak dollar helped the US economy post a better than expected 3.9 per cent growth
in the third quarter, as exports accelerated, imports slowed and the trade deficit
narrowed. Though consumer sentiment has declined in recent months, it is yet to
reflect appreciably on consumer spending and corporate investments remain strong.
If that were
all, the Fed would probably have decided to hold rates - as one of the governors
wanted to. But, there are no signs of the mess in housing clearing up anytime
soon. If anything, the decline in home prices and sales has only accelerated in
recent months. Some studies show average home prices in the US have to fall by
another 10 per cent or more to revert to their long-term trend. If the sell-off
accelerates, it is quite possible that prices may fall even more before they recover.
If that happens,
credit markets may be in for more trouble. The more pessimistic analysts have
estimated potential losses of over $400 billion, if housing remains depressed
for the next year or two. Against that, what the big lenders have so far booked
is only less than $40 billion. The Fed had to pre-empt at least a fraction of
this risk and lessen the fallout if indeed it turns to be as bad as feared. Though
economic growth in the second and third quarters has been better than forecasts,
not many expect the trend to continue in the last quarter. Housing weakness and
the third-quarter disruptions in the financial markets may lower growth to below
1.5 per cent, according to most forecasters. If another market scare happens when
the economy is more vulnerable, the consequences could be disastrous. The Fed
could not have ignored this risk and hence the 25 basis points cut. What
has disappointed some investors is the renewed emphasis on inflation, which they
consider unnecessary, and the balanced outlook from the Fed. They were praying
for a gloomier outlook that would have made future rate cuts more certain. Their
wishes have not been granted and obviously, they are complaining. ''Recent
increases in energy and commodity prices, among other factors, may put renewed
upward pressure on inflation,'' the Fed said in the statement. That is probably
a mild statement to make when oil has crossed $96 to a barrel and other commodity
prices are also scaling record highs almost everyday. And if markets are complaining
about the ''harsh'' tone, it should be a warning to the Fed - and other central
banks as well - about the challenges it faces in managing market expectations.
The
Fed is clearly playing it safe when it says "the upside risks to inflation
roughly balance the downside risks to growth". The tone is very clear - ''we
have done what the markets expected us to do by cutting down rates by as much
as 75 points and pulling out reckless investors and institutions from the stinking
mess they created. Now don''t count on us to keep playing the music so that markets
can party on and then deliver another dose for the hangover as well''.
If only the markets would
pause and listen, instead of behaving as if the party will go on forever!
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