After lengthy discussions, the US Federal Reserve Bank took the markets by surprise by opting for a larger than expected 50bp cut in its Fed Fund rate on Sept. 18 to 4.75 percent. This was the first cut in rates for nearly four years, and for some, it seemed to signal that the Fed might now revise its previous policy of rate rises to control inflation, and instead focus on bolstering flagging consumer confidence and jittery credit markets. However, a closer reading of the Fed’s accompanying statement to the rate cut seems to indicate the contrary, with significant consequences for the Gulf economies whose own monetary policies seemed to have been put into turmoil following the Fed’s decision.
What emerged from the Federal Open Market Committee (FOMC) meeting on Sept. 18 was that what was initially a unanimous decision to cut the Fed fund rates by 50bp was built around two tactical arguments by the US Central Bank. The first argument was couched in language that was meant to convey that the cut was a policy response directed at averting a deepening of the downside risk of a recession — in effect, to buy time for the US economic outlook to become clearer. A 25 bp cut would have muddied the economic horizon, and put further pressure on another rate cut sooner than later.
The second argument was built around inflation — also now of major concern for all Gulf economies. The Fed reminded the financial markets that they have not abandoned their inflation watch and vigilance, and seemed to suggest that the FOMC members do not expect a momentum for further interest rate cuts to follow through unless new economic data is worse than expected. A policy of constructive ambiguity on further interest rate cuts suited the Fed right now. Indeed, rates could go up again, given that the accompanying note to the recent interest rate cut openly stated that “inflation risks remain.”
The upshot for the immediate term, and for “Fed watchers,” is that the US central bank will continue to stress these two important distinctions in their arguments — namely, that there is a parallel policy on track which is responding to the financial risks of the economy, as well as one of a financial market credit related instability.
In some sense the two messages are interlinked, as the tightening of financial market conditions over the past few weeks — as exemplified by the Northern Rock panic in the UK — is clearly seen as potentially intensifying the risk to growth in global economies. The larger than expected cut in the Fed Funds rate was more intended however, to forestall any further financial panic spillover, rather than as a means to stabilize financial markets directly. Avoiding a global financial panic contagion and rollover risk, is indeed a concern for both the Fed and other central banks around the world. However, it seems that central bank intervention, by pumping in adequate liquidity, will be the main central bank tool that will be used to ensure that interbank settlement and trading continues to function smoothly. Some central bankers were praised for acting faster than others in this regard, but to all intents and purposes, central bankers have learned their lessons in this latest credit crunch. The central banks believe that this, rather than cutting back on interest rates, is the better way forward to allow the markets to re-price risk and begin to lend term funding at appropriate credit related pricing. It was interesting to note that both the Bank of England and the European Central Bank — the latter, despite some pressure from France but support from Germany — decided to hold back from following the Federal Reserve and cut back on their interest rates, believing that the fight against inflation was far more important. Regionally, the same principle seemed to have prompted SAMA’s refusal to follow some other central banks in the Gulf and cut back on interest rates, instead allowing the Saudi Riyal to retain a premium over dollar interest rates. Domestic inflation, spurred on by high liquidity, would not be fueled by cheaper riyal facilities. Domestic credit markets would re-price risk at a higher interest rate differential. The needs of the Saudi economy became paramount, as SAMA’s Governor Hamad Al-Sayari made it abundantly clear in a recent rare press statement. The Federal Reserve was also applying the same principle in its accompanying message to the September interest rate cut. It would not be surprising to see the re-emergence of an emphasis on financial risks — i.e. inflation, to the US economy, as opposed to market credit related risks. As such, a repeat in interest rate cut by the Fed is not guaranteed.
Dr. Mohamed Ramady is visiting associate professor, Finance and Economics at King Fahd University of Petroleum and Minerals.