The US Federal Reserve, under its new Chairman Ben Bernanke, took the markets by storm, when in January it cut interest rates twice to 3 percent, followed by a 75 basis point emergency cut in March and another 25 basis points in April to take US interest rates to a 45 year low of 2 percent. It was the Fed’s “inter-meeting” cut of 75 basis points in January — the largest cut in interest rates in 26 years, which was calculated to calm tumbling stock markets. It did not work. According to the Fed, the US financial markets remain under considerable stress, and credit has tightened for businesses and households. With financial markets in a meltdown, the Fed was in a quandary. What next then for the Fed to revive economic confidence? More importantly, has the American central bank under Ben Bernanke begun to adopt a strategic new shift in monetary policy, different from his more cautious predecessor Alan Greenspan, and what is the implication of such a new policy on the Gulf countries?
There are already some critics of this seeming proactive Fed monetary policy, who are criticizing the Fed for bowing to the short-term priorities of the distressed financial markets. By cutting 75 basis points twice in less than two months, the Fed, it is argued, was not leaving much room in the future for adjustments. The Fed, like most analysts, is groping in the dark given the spate of anemic economic data. Bernanke has put his reputation and future on the line by taking absolutely enormous stakes of the “timely and decisive” bets he has made in his embrace of a new Fed policy that smacks of an aggressive, preemptive risk management approach.
This makes two assumptions: that the $14 trillion US economy has entered into a sharp recession and needs such shock therapy treatment, or has entered an extended period of weak economic growth that smacks of a recession but is not as bad, and that nervous consumers will rebound back. If the latter is the case, and the US economy recovers much faster than expected, would this then set off another round of inflation and Fed anxiety on raising interest rates, just as precipitously as having lowered them? Many countries around the world are anxiously watching what happens to the US economy and take appropriate domestic measures concerning their own economies. For OPEC, this means whether to reduce or increase oil production quotas. For the GCC, it adds further pressure on whether to maintain their fixed parity against the dollar.
What has set Bernanke apart from Greenspan is that the current Fed chairman has essentially staked his claim on a second term as chairman on the sharp rate cut decisions, compared to two decades of a gradualist policy under Greenspan. The new chairman seems keen to introduce a more modern approach of monetary policy not practiced earlier. This is probably helped by the fact that both Bernanke and some others on the Federal Reserve Board are ex-academics, who had been accused of being too insensitive to the signals of the market, thus leaving the American central bank always lagging behind credit market conditions. These ex-academics have now taken the gloves off and seem to have learned the lessons of the first half of 2007, when the financial markets consistently priced in rate cuts, despite Bernanke sticking firm and stating in public that no such cuts were forthcoming.
The new policy being adopted seems to be based on a finely tuned two front response of the Fed — trying to keep the markets liquid, through cuts in the discount rate, while keeping the changes in the Fed funds rate targeted at the real economy. This new proactive approach has been dubbed as “risk-management,” and is based on the following crucial caveat. Assuming that inflation expectations are under control, then monetary policy should be more “flexible”, with short-term rates now cut more aggressively and “front-loaded”, since the longer the Fed waits for economic sentiments to turn around, the deeper will be the damage to both the financial system and the real economy. If such an aggressive, proactive monetary policy is not followed, and then the argument runs, that if left to its own momentum, an “adverse market feedback loop” could develop a central banker’s nightmare.
Here, fear and loss of confidence becomes entrenched, and this restrains the flow of credit to the real economy, thus reducing the prospects of economic outlook further. This in turn causes that most dreaded of sentiment in financial markets — uncertainty, leading to falling collateral valuations, capital losses, further cuts in lending and a worsening economy. This is not theoretical stuff, as the collapse of the UK’s Northern Rock and the fifth largest US investment house Bear Stearns vividly illustrated.
Under the new Fed approach of “risk management”, the US central bank is pricing its monetary insurance policy on what it believes as the best estimated neutral or equilibrium interest rate of around 2.5 percent. The current 2 percent US interest rate provides an elegant platform from which to determine if further cuts are needed or held steady for a longer period of time.
And what of the upside risk? The new model Fed policy must also be able to take into account an upward bias in inflationary expectations, which will call for a more traditional, forecast-based monetary policy that is reaction orientated. This means that the Fed will also act more quickly and aggressively on the upside to take back the “insurance” premium, and communicate such moves to the market. What the Fed does not want to do is to create a false sense of central bank market support — the markets must not become too dependent on the Fed to bail it out at every sign of weakness due to internal control mismanagement and mispricing of credit risk.
How long will this new Fed policy last? By all indications, for some while yet, as there seems no end to the collapse of the sub-market credit bubble. This will be uncomfortable for the GCC countries that are grappling with rising inflation, liquidity injections and a forced reduction in their own interest rates due to the dollar cuts. The pressure to de-link their currencies in a modest way will grow. Watch this space, as they say...
(Dr. Mohamed A. Ramady is visiting associate professor, finance and economics, at King Fahd University of Petroleum and Minerals, Dhahran.)