Another cut in US interest rates

The United States Federal Reserve has once more moved to lower interest rates in an aggressive move to bolster confidence and demand in their flagging economy. This BBC news audio-visual clip looks at the immediate market reaction. Just about every macroeconomic policy lever is now being pulled in terms of monetary and fiscal policy and it will be fascinating to see what impact the loosening of macroeconomic policy has on the economy.

Ben Bernanke has indicated that he is prepared to cut rates even further if necessary, a stark contrast to the inactivity at the Bank of England. The fact is that the drivers of monetary policy decisions in the United States tend to err on the side of economic growth whereas the sober bankers on the Monetary Policy Committee take a sterner line on inflation risks. Whose side are you on?

Big cuts in short term interest rates

The Bush tax rebate plan affecting over 100 million Americans which might inject an extra $150 billion into the economy

Investment tax breaks for business

A lower dollar exchange rate providing a boost for US exporters

The International Monetary Fund has come out in support of using a fiscal stimulus to manage demand, output and jobs. Writing in today’s Financial Times, the new Head of the IMF Dominique Strauss-Kahn argued that

‘The first line of defence remains monetary policy. If growth slows and inflation remains under control, there is scope for cutting interest rates. Of course, countries face risks to inflation, from global forces such as oil prices or from internal ones such as a strong push for higher wages ......But monetary policy may not be enough. Why? There are two main reasons.

First, the transmission mechanism for monetary policy is damaged. While cutting interest rates is still effective, it may not work to stimulate investment and consumption as fast as usual. Banks have suffered substantial capital losses and thus want to consolidate their balance sheets and avoid taking on additional risk. Moreover, normally low-risk assets (such as jumbo mortgages in the US) are at present regarded as higher-risk. These impediments may slow down the positive effects of monetary policy.

Second, there is a risk that if a slowdown really takes hold, it will be hard to shake off. The US and some emerging markets have a history of bouncing back quickly. Other countries, including some in Europe and some in the developing world, have traditionally found a rapid recovery to be more difficult.

Timely and targeted fiscal stimulus can add to aggregate demand in a way that supports private consumption during a critical phase. Of course, it has to be temporary - there is still much work to be done to get ready for the approaching retirement boom. And it has to focus on adding to aggregate demand quickly. In a sense, medium term fiscal policy is all about saving for a rainy day. It is now raining.’

I can see why both the Fed and the US government are desperate to avoid a severe deceleration in growth which will take a sizeable slice of the domestic economy into recession territory. Indeed the state of the economy has overtaken geo-political and military concerns as the salient issue in the US Presidential election race. The decline in house prices and construction may well turn out to be a major demand-side shock for the economy which will inevitably take some stopping. But when asset prices have been driven so high and household saving has collapsed, the rebalancing of the economy is likely to be abrupt and painful. That said, a readjustment is badly needed and put simply, Americans need to save more - they have been spending like there is no tomorrow and perhaps they know something that we don’t!

The Fed has cut interest rates decisively - we are about to see whether the US economy is about to experience a liquidity trap when monetary policy operating through domestic spending and savings decisions becomes impotent.

Futher reading

Fed slashes interest rates (Independent)

Bernanke cuts rates to avoid recession (The Times)

Guardian special reports on the US economy

BBC News “US Economy at a Glance”