labels: Bank general
The Fed's painful dilemmasnews
Vivek Sharma
12 December 2007

The 25 percentage point rate cut has disappointed the financial markets. While more rate cuts are likely next year, possible global slowdown and inflation pose bigger risks for investors.

Imagine you are the parent of a rather demanding, temperamental and impulsive teenager. Having been brought up in a reward and punishment-based training system, the kid expects incentives for performance. Though you are supposed to deliver both reward and punishment as the situation demands, as a parent you often find it difficult to punish your child even when he misbehaves or makes a mess of things. Sometimes, your reaction to the kid's misbehaviour is to dole out more incentives in the futile hope that things will be mended.

Last summer, when your kid got himself into that huge mess, you were really scared for him and decided to pamper him back to the good ways. Oh, he loved it and was the perfect child for a couple of weeks. Then he started anticipating the next big incentive and kept reminding you about it. When the time came, you were a bit cautious but gifted it to him anyway. He was a trifle disappointed, but did not protest too much as he was still on a high from the previous big gift.

But the incentives did not work that well. Your kid went back to his bad ways, and you became increasingly concerned. He kept reminding you that it is time for the next big gift. You often made some positive statements, more to pacify him, but he took it as an early confirmation of the next big one.

When the time came to deliver the goodies, you were a bit concerned that a big incentive at that point may make him too exuberant and could harm him. After all, you tried to reason, too much of anything is bad for anyone. And you decided to be cautious, but give him an incentive anyway. But the kid is shattered. He calls you heartless, unconcerned and a miser to boot. You are perplexed.

That is how the US Fed chairman Ben Bernanke must be feeling after delivering his latest gift to the financial markets a 25 basis points Fed rate cut yesterday. He gave the markets a big 50 points cut in September and followed it up with a 25 point one the next month. But the markets kept asking for more as the credit crisis deepened and US consumer sentiment appeared to be faltering.

The tribe of economists predicting a US recession next year are growing by the day. Despite the Bush-Paulson bailout package for sub-prime borrowers, most expect the housing market to remain depressed for at least a couple of years more. The massive haemorrhage in bankers' income statements from their past sub-prime mortgages binge remains uncured. They are rushing to plead before the Arab oil sheikhs and Singaporeans for more capital to survive.  

Despite the earlier Fed rate cuts and liquidity infusion, credit markets have not fully recovered. Some of the leveraged buy-out deals announced before the crisis have been called off. Credit standards have been tightened and businesses are less hopeful of easy credit availability in the short to medium term.

No, oil did not scale the $100 peak and has corrected more than 10 per cent over the last few weeks. But, high fuel costs continue to burden American consumers already hurt by falling home prices. Consumer sentiment has slipped in recent months and retail spending is likely to be weak for the next few quarters.

The weak dollar has helped American exporters and, in turn, the manufacturing sector. But sustained export performance will depend on global growth momentum, outlook for which has turned murkier. Numbers of ardent believers in the 'decoupling theory' which predicts sustained global growth even if the US economy slips into a recession have been dwindling. Besides, the dollar may not decline fast enough to compensate for subdued global demand growth for American exporters. In fact, there are many who now predict a short to medium term dollar rally. That could prick American export buoyancy.

All these negatives beg for pre-emptive measures like a Fed rate cut. Next year's US presidential election makes the Fed's job even dicier. No government would like to go to elections with the economy in doldrums. So there will be increased political pressure, mostly from Republican politicians - if not directly from the administration, on the Fed for bailout measures.

But, it is not so easy for the Fed. The economic weakness evident in most other indicators is still not reflecting in jobs data. Job additions in November were higher than expected, though most economists believe that the US economic growth will be less than 1 per cent for the October-December quarter. If economic weakness has already set in, why are businesses hiring more? That remains a riddle, unless the US labour department does a flip-flop in coming months and say the jobs data was erroneous on the higher side.

The strong jobs data forces the Fed to be watchful about inflation. Consumer inflation remains comfortable, but the risks remain. Commodity and energy prices have not corrected appreciably to ease the pressure on inflation. If the labour market is indeed tight as made out by the jobs data that is an added concern.

So, the Fed decided to take a 'neither here, nor there' step by cutting both the target fed rate and the discount rate by 25 basis points each. One member of the FOMC the Fed committee which decides on monetary policy voted for a bigger 50 basis points cut, which shows it was not an easy decision to take. But, the Fed has tried to buy itself some more time, watch the evolving action and then move accordingly. Given the market expectations for a big cut, the Fed could not have kept the rate steady. That would have led to a bloodbath in the markets.

But, the Fed also deserves some blame for coming out with muddled outlooks at different points. In August, the Fed was confident about economic growth and its ability to manage inflation. The sub-prime triggered market meltdown led to a swift change in the Fed's outlook and prompted a bigger than expected 50 basis points cut in the fed rate.

That was the equivalent of the CIA's recent finding that the Iranians are not as bad as previously thought. In October, while announcing a 25-basis points cut, the Fed said the risks to inflation and growth are balanced implying a neutral policy stance. Given the severity of the credit market crisis, that was a bit premature.

The market bulls need not despair so soon, if it is only rate cuts that they desire. The Fed is likely to cut further next year. But the bigger risks for investors are the possibility of slowing global growth and rising inflation. Equity markets are priced to perfection for sustained global growth, and manageable inflation levels. If growth falters, demand slips and corporate margins take a hit, the 'not-so-expensive-given-the-strong-earnings-outlook' valuations will look obscenely expensive.

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The Fed's painful dilemmas