Tough choices

Malaysian Business, Feb 16, 2008 by Nor Zahidi Alias

MAKE A GUESS. WILL THE US FEDERAL RESERVE Bank (Fed) continue to slash its policy rate during the rest of 2008 or just stop at the current level of 3%?

Normally, analysts would start scrambling for data and historical speeches by central bankers. Not this time, though. Such a question is not difficult to answer at this juncture, looking at sentiments in the financial market. The turmoil and actions by the Fed have certainly given a clear signal about the way interest rate winds are blowing.

The Fed shocked the market in the third week of January by slashing its benchmark federal funds rate by 75 basis points, the biggest cut that has happened in between meetings. A week later, another 50 basis points were trimmed, bringing the borrowing cost down to 3%. At the same time, the discount rate - the rate at which banks can directly borrow from the central bank - was cut to 3.5%.

But that may not be enough. The financial market keeps on flashing signals that possible dire consequences of the recent credit rout will continue in the near future. Not surprisingly, a majority of traders are still looking at deeper cuts by the Fed in the next few months. At the time of writing, the futures market was indicating a rate of 2-2.5% by the end of the year, at least another 50 basis points lower than the current level.

Would the Fed keep on adhering to the financial market's desire to see lower interest rates? Is the Fed really bailing out the financial market again after its previous chief, Alan Greenspan, was accused of starting the housing bubble in the late 1990s and early part of the new millennium?

The arguments seem never-ending. Prominent economist Stephen Roach from Morgan Stanley harshly criticised the Fed's decision (to cut interest rates), describing it as `dangerous, reckless and irresponsible'. He added that `by cutting rates to protect growth when bubbles burst, the Fed only encourages investors to take bigger risks in the future'.

Similarly, billionaire George Soros said that central banks have `lost control' of financial markets. Former US Treasury Secretary Lawrence Summers slammed the Fed by saying that central banks have not done a good job over the last couple of years `on recognition of bubbles and actions taken to address them in the policy or regulatory sphere'.

There are of course other views from different camps. People are losing their jobs and a collapse in the housing market will likely temper consumer spending in the months to come. At the same time, many believe that Keynesian prescriptions are still among the best in alleviating downward economic spirals.

As for criticism of the need to deflate bubbles before they burst, Greenspan and present Fed Chairman Ben Bernanke are right to point out that they are hard to recognise until they have actually emerged. Pricking the bubbles at the wrong time would have dire consequences on the economy.

Despite the harsh criticism, Bernanke's Fed will likely maintain a deaf ear to such talk. When they foresee the need to change the rates further, they would do it without hesitation. After all, only those who sit around that table at the Federal Open Market Committee (FOMC) meetings would know what it feels like to make such a decision.

To gamble against economic growth would mean risking seeing many Americans losing their sources of income, their homes and even their pride. To punish a small group of reckless investors who gambled in the real estate business in the past few years may result in putting more people under unemployment insurance. Tough choices.

The fact that the Fed had aggressively slashed interest rates in the past month however raised some eyebrows among investors. Does the current situation call for such serious actions? Does the Fed know more than investors about the seriousness of the problem? Have other economists underestimated the current turmoil?

There are apparently a lot more questions than answers. But there is compelling evidence that the United States is already at the doorstep of recession, at least based on some macro data.

First and foremost is the leading economic indicator, an indicator that normally predicts the upcoming change in an economic trend. The indicator has never failed to foresee an upcoming recession since the 1970s.

Prior to the recession in the early 1980s, the leading indicator contracted for 23 consecutive months since as early as April 1979. Over the period, it fell by an average rate of 6%.

Following that, the Gross Domestic Product (GDP) experienced its first contraction in first quarter 1982 after the Fed kept interest rate stubbornly high to ward off inflationary pressure, which occurred during the last part of President Jimmy Carter's administration. Contractions in economic activity lasted for four quarters, leading to a full blown recession in the US.

During the 1991 recession, the leading indicator fell into negative territory for 26 consecutive months from May 1989 to June 1991. The average contraction over the period was 1.7%. Consequently, the economy was mired in a recession after two consecutive quarterly contractions in 1991.