In his book, Age of Turbulence, Alan Greenspan repeatedly stated that it’s not the Fed’s job to worry about the stock market. Rather, the Fed is charged with the task of striking the right balance between inflation and growth in GDP. (This differs, by the way, from the Bank of England and European Central Bank, which are supposed to focus solely on inflation.)
Yesterday, the Fed did the opposite of what Greenspan suggested it should do, and quite clearly put the interest of traders and investors above all else.
The announcement of a 0.75 per cent cut in rates, the biggest one-day cut since 1982, was relevant to US inflation and US growth in one respect only.
The move carried massive psychological impact. If the chairman of the Fed was a PR man, he would have recommended yesterday’s move. Bernanke certainly won the headlines – and in so doing sent a message to banks, borrowers and consumers: “Don’t panic,” he said, “Uncle Ben is here to help.”
But that was it. The economy is not like a Formula 1 racing car, which reacts almost instantly to a press on the brakes, or pushing down the gas. Rather it is like a cruise liner. Perhaps one of the most memorable moments in James Cameron’s film ‘Titanic’ was when the iceberg was spotted, and despite the efforts of the crew the ship just couldn’t turn around fast enough.
The relationship between changes in the rate of interest, and inflation and growth, has a time lag built into it. It can take as much as two years before a change in rates has its full effect.
If the Fed had chosen to lower interest rates at the end of the month, when it was due to meet, the economy’s performance would not have been affected – at all.
If the Fed had made its announcement yesterday afternoon, it would have made no difference. Instead it went for maximum impact, revealing its latest cards first thing in the morning – so that the markets had all day to ruminate on the move. So the markets had no reason to start the day off with a panic sale.
And in that one respect the Fed’s move was an unqualified success. Sure, the Dow was down 128 points, but some analysts believe that if the Fed had not made its announcement, the index could have plunged by 600 points, or more.
Many economists believe the US could be in recession – right now – even as you read this. Yesterday’s move will have no impact on this.
But, the rate cut will give borrowers a huge lift. Both indebted businesses and individuals paying interest at a rate that changes with the official US discount rate, will soon be much better off.
Couple this with George W’s move earlier in the week to give out a $150 billion tax boost, combine this with the money flooding into the US from sovereign funds, shoring up bank balance sheets, then throw into the pot the various occasions in recent weeks in which the Fed has pumped money into the system. Right now the US is fighting back.
Was Bernanke right to take such drastic action yesterday? In an interview on Radio 4’s Today programme, George Soros said he was right. “I think you do have to rescue markets, otherwise you go into depression like you did in 1930,” he said.
There are serous risks with the move, however.
If in cutting interest rates the Fed makes things easier for debtors, and enables people to avoid bankruptcy, or house possession, then the move was a good thing. If on the other hand, it encourages a new borrowing frenzy, if people just go out and borrow some more, perhaps they borrow to pay off existing borrowings; then that is a bad thing.
If the cut in rates leads to further falls in the dollar, and if the price of oil starts to go up again, then inflation will pick up.
Ben Bernanke once said, famously, that the solution to a credit crisis was to get into a helicopter and spray money across the land. This earned him the nickname of helicopter Ben. Well, he has done that. In this week’s Economist, the front cover showed a fleet of helicopters, this time depositing money from the sovereign funds. The last few weeks have seen the economic equivalent of shock and awe, a full-frontal aerial strike – helicopters carrying money from the Fed, helicopters from the People’s Republic of China, and Arab states, carrying economic aid; F15 jets firing $150bn-worth of tax boost, and now a missile loaded with a 0.75 per cent cut in rates.
But, supposing it is not enough?
George Soros said this morning, that he believed the US will hit recession, and the UK may well follow in its wake.
Maybe the battle we are now seeing being fought is not to try and avoid recession, it is not to try and kick-start the economy. Rather, we are seeing an attempt to avoid the US following Japan, and hit depression. The fear has to be that the price for avoiding this depression is even more debt – increasing the dangers of an even-more severe economic shock in the years to come.
What we really need is not for an air strike carpet-bombing the economy with capital – what we really need is the foot soldiers of China and India – the consumers, to go out and spend more of their county’s new wealth.
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