What Should We Deduce from the Sudden Dramatic Cut in US Interest Rates?

Location: New York
Author: Shahin Shojai
Date: Thursday, September 20, 2007
 

While such a move has been received very positively by the markets it is not clear why it was actually done; at least not to me. We were all led to believe that the crisis in the credit markets was simply an aberration, a short-term market dysfunction, which could be sorted out with the central banks providing cheap credit to the financial system. Even though I personally could not understand the difference between providing billions of dollars to the financial system at subsidised rates and actually cutting interest rates, it still made more sense than the current 50 basis point cut in interest rates.

If the problem was of a short-term nature then the reaction of the major central banks a few weeks ago should have helped calm the markets. The reaction of the U.K. government and central bank to the problems of a local mortgage lender, Northern Rock, has also been helpful in preventing a major run on the bank. Consequently, the willingness of the central banks to stand by and correct the aberration should have been enough to calm the markets and ensure a smooth transition back to normal.

If that was in deed a short-term crisis, why has the Fed cut rates by so much, especially if, as they had suggested, the U.S. economy was strong enough to withstand the recent credit crunch. Could it be that they are worried that the problem could get more widespread than many had thought and felt that they should react very aggressively to prevent the current problems turning into a major economic crisis? If that is in deed the case, then why are the markets reacting so positively? If the Fed is giving the markets the signal that the economy was, and perhaps still is, in a bigger danger of major slowdown than many had thought, possibly precipitated by the recent credit and housing problems, then the markets should react very differently. The markets should realize that the Fed is worried and react accordingly. Unless, of course, they believe that a 50 basis point cut is enough to prevent a major economic slowdown. Given that most had, and still have, no idea the economy was facing such a crisis it would be surprising that they were able to determine so quickly that the cut was enough to help prevent what the Fed is worried about.

In my mind, the main problem is that if the economic slowdown could have been as severe as the half a percentage cut suggests then maybe it might not be very effective, and more cuts might be needed in the future, in which case there is a very serious risk of inflation getting out of hand. The Fed has taken a huge reputational risk with this cut. If, as a result of this cut, inflation does get out of control the Fed might have caused serious damage to its main monetary policy tool, namely its reputation.

My only worry is that Dr. Bernanke might be making the same mistake that many new central bankers make when they face their first crisis after taking office, and that is to try and prove to the markets that they are strong in times of difficulty and to appease the markets. His predecessor did just that after the 1987 market crash. However, Dr. Greenspan is still accused by many for cutting the rates too fast and not raising them fast enough after the stock market bubble burst in 2000, causing the property bubble that we are now seeing burst. Could Dr. Bernanke create another bubble by his latest actions? Only time will tell, but from my point of view the reaction of the markets proves not much time was spent analyzing the message that the announcement was trying give to the markets.

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