Global Insight Perspective | |
Significance | On cutting rates back to levels not seen since 2003–04, the U.S. Federal Reserve made no bones about the escalating domestic and international downside risks. |
Implications | The central banks' decisions have been made easier by falling inflation, previously the major barrier to cuts. Markets in Asia and Europe have greeted the institutions' proactive stance with strong rallies. |
Outlook | The U.S. financial system may have stabilised to a degree, but the economies of the United States and many other leading countries are already sinking into a painful recession. Global Insight expects U.S. rates to fall another 50 basis points in the coming months. |
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The Fed Cuts Again
The Federal Open Market Committee (FOMC) voted unanimously yesterday to lower its target for the federal funds rate by 50 basis points, to 1.00%. The discount rate was reduced by the same amount, to 1.25%. The federal funds rate is now back to the all-time low it last stood at back in 2003–04. As recently as August 2007 the rate stood at 5.25%. This begs the question of how much further it can fall—the Fed has fewer policy options as the figure approaches zero. The FOMC stated that the economic outlook had deteriorated due to a decline in consumer expenditures, while business equipment spending and industrial production have weakened. Moreover, sharp slowdowns in overseas economies are expected to lead to a deceleration in the growth of U.S. exports. Adding to these recessionary forces, the intensification of financial market turmoil is expected to exert additional restraint on spending, as credit conditions remain very tight. With the recent sharp drop in commodity prices, the FOMC expects inflation to moderate to levels consistent with price stability. In effect, the FOMC has removed inflation from the list of major risks to the outlook.
The Fed has broadened and amplified its response to the escalation of the financial crisis and the recessionary forces now gaining momentum in the economy. In the month of October, the Fed has slashed interest rates by 100 basis points, and also committed to almost US$2 trillion of additional short-term lending in the next few months under the term auction facility (TAF), and new money market fund and commercial paper facilities. That is a massive commitment to unlocking the credit markets.
China Leads the Way in Asia
In Asia, the latest round of interest rate cuts was led by the People's Bank of China (PBoC), marking the second move in lockstep with U.S. authorities. The benchmark rate for one-year loans was lowered by 27 basis points to 6.66%, standing as the third adjustment in six weeks. The interest rate on one-year certificates of deposit was reduced to 3.60% from 3.87%. Across the Straits, Taiwan's central bank also lowered its leading rate by 25 basis points to 3.0%—the second cut in the space of four weeks. Despite widespread speculation that it would implement its first cut in interest rates in seven years; the Bank of Japan stayed its hand, keeping its leading rate on hold at 0.5%.
Although no statement was released to accompany the reduction in Chinese rates, the motivation remains clear as the economy's outlook darkens. The shift to an aggressive easing stance has been accompanied by large-scale fiscal stimulus and administrative measures, including renewed increases in export tax rebates to massage growth. Growth still remains firmly skewed to external demand, with the United States, Europe, and Japan accounting for 50% of total exports, fuelling in turn a major investment cycle. Even prior to the escalation of the financial crisis in mid-October, exports in real renminbi terms had been steadily decelerating since September 2007. The risks associated with a slowdown in growth are exacerbated by excess capacity in the economy, while firms operating at low profit margins may face difficulties in financing existing liabilities in the event of a downturn generating fresh stress in the domestic financial system. Domestic growth is being hit by a downturn in the once-booming property market, which accounts for around one-quarter of total fixed-asset investment, and by the plunge in stock markets. Ostensibly, the co-ordinated action by the PBoC is a demonstration of China's commitment to act as a mature stakeholder in the global economy, but the reduction in rates is also aimed at reducing appreciation pressures on the Chinese renminbi as the interest-rate differential widens. Further monetary easing is expected with cuts expected to be bunched to maximise the impact.
Norway meanwhile cut its benchmark interest rate to 4.75%, the second time in two weeks (see Norway: 30 October 2008: Norwegian Central Bank Cuts Key Interest Rate by 50 Basis Points to 4.75%).
Markets Recover Some Ground
Expectations of the U.S. rate cut spurred initial gains for the Dow Jones Industrial Average yesterday, although in the end it closed down 74.16 points. Many markets in Asia and Europe gained strongly yesterday, by comparison, and this pattern has continued today. South Korea's benchmark Kospi index closed up 12% today, its biggest-ever single-day percentage gain. News that the South Korean government has arranged a currency swap agreement with the U.S. Federal Reserve contributed to the advance. In Japan the benchmark Nikkei index was up 10% to 9029.76, while Hong Kong posted a 12.8% gain. China's Shanghai Composite rose by a more modest 2.6%, while Australia's S&P/ASX 200 ended the day up 4%. U.S. futures are pointing to strong gains in trading today, and the European markets have moved up in early trading. The U.S. dollar has slipped back somewhat against currencies it had been battering over recent days, including the Canadian dollar and British pound.
Outlook and Implications
It is clear that the Federal Reserve has moved from a defensive, case-by-case crisis management approach in the middle of the year to an offensive and comprehensive attack on the deflationary forces in the economy and the credit markets during October. By removing inflation from the list of major risks to the outlook, the Fed is essentially giving itself carte blanche to move ahead at full speed, using all tools and facilities at its disposal. Clearly, the last month represents a watershed in terms of the approach taken by the Fed, and we believe that this is a positive signal for the ultimate resolution of the crisis. That said, we are projecting that the Fed will lower interest rates by an additional 50 basis points over the next several months, to historically low levels for federal funds, as the recessionary conditions in the economy will be become even more apparent in reports on the economy during the fourth quarter of 2008. Further rate cuts are expected internationally, not least from the European Central Bank and Bank of England when they meet next week.