The Hindu Business Line : Fed rate cut: A fait accompli?

Its charter mandates the US Federal Reserve to hold at least eight meetings of its rate setting Federal Open Market Committee (FOMC) every calendar year. Likewise, the Monetary Policy Committee (MPC) of the Bank of England (BoE) is required by law to meet at least monthly to deliberate on economic developments and formulate an interest rate decision which it judges will enable an inflation target to be met. Following these mandates, both the Fed and the BoE (indeed other m ajor global central banks also) lay out a calendar of dates on which their key interest rate committees meet and decide on rates.

A meeting frequency of about a month to set interest rates is not only a reflection of the dynamic and complex nature of modern economies/financial markets and the challenges they consequently pose for policy-makers. It is also a reflection of the great strides which have been made in making the esoteric subject of central banking more transparent and open to public scrutiny and thereby make it more understandable for the common man. The practice of making public the minutes of the FOMC/MPCs meetings and central bank officials testifying before Parliament/Congress are also part of the efforts to make central banking, so to say, end-user friendly.

The power of being the lender of last resort, in a sense, gets magnified in a system where monetary impulses are transmitted smoothly (from a short-term interest rate decision of the central bank through the term structure to aggregate savings, spending and investment behaviour) and this is another key reason why central banks and their operations are subject to more scrutiny in such a system.

The foregoing does not imply that policy-makers are strait-jacketed into a structured meeting pattern and cannot deliberate/act outside of the schedule. The very complexity of modern financial markets and the way they impact the real economy present a good case for policy-makers to be bestowed with a good degree of operational flexibility also to respond to emergency situations. Indeed, they have been vested with such powers which have been exercised also in the past two decades.

Rate decision on Sept 18

Be it as it may, one such scheduled meeting of the FOMC is slated for September 18. And, for once, the top policy-makers at the US central bank may well feel that a meeting had not been scheduled for this date. For, financial markets and economic agents have so arrayed and positioned themselves that a rate cut at the meeting now seems a fait accompli for the FOMC.

Interest rate derivatives markets were pricing a high 95 per cent probability of a 25 bps cut while the chances for a 50 bps cut were around 75 per cent as of mid last week. The data on September 14 — retail sales and consumer sentiment — presented a mixed picture and along with on-going credit market developments have lowered the chances of a 50 bps cut somewhat. But the present nevertheless seems to be a time when the Fed possibly feels that its hands were not tied and forced by the market’s expectations. Sentiments in the markets now seem to be so fragile that if the Fed were to not cut as per expectations, the markets could well spiral down further (taking the real economy also down) in a self-fulfilling prophecy.

The Fed ideally, though, may like to observe the impact of its discount rate action of August 17 over a longer time frame before deciding if the temporary liquidity support which the discount window provides needs to be scaled up and structured as more permanent relief by a reduction in its target interest rate.

The Bernanke Fed has attempted to be different in its response to the on-going financial markets crisis. It has not preferred the quick-fix approach of the Greenspan Fed which may have seen the US central bank cutting its official target interest rate at the first sign of serious trouble in the financial markets. Indeed, the discount window action, by targeting liquidity relief at those institutions actually needing it, seemed to be a balanced response to the liquidity/credit squeeze in the markets and structured to be in tune with the Fed’s twin objectives on economic growth and price stability.

While targeting liquidity relief, the Fed also went further by (moral) persuading large, complex financial institutions such as Citigroup and Bank of America to borrow from the discount window even if they did not actually need emergency liquidity support. This was done more to remove the stigma which is generally attached to borrowing from the discount window and, thereby, encourage smaller and more vulnerable institutions to avail of discount window funding to tide over the liquidity difficulties.

The legacies of the past nevertheless seem to be so strong that not much more time may be given the Fed to study the effects of its discount rate cut of August 17. Some of the intervening economic data — most notably August non-farm payrolls — have also come in negatively and this has added to the pressures on the Fed for guiding all dollar interest rates down.

Qualitative difference

In this context, it is interesting to note the subtle difference between the responses of the Fed and the Bank of England to the financial markets crisis.

Both the Fed and the BoE have provided emergency liquidity support to those financial institutions which have seen markets in some of the assets they hold dry up completely and consequently being not able to access continued funding from the wholesale markets. That is, both the central banks have, in the first instance, tried to localise and contain the difficulties in the financial markets by providing targeted relief. They have tried to avoid a general interest rate cut as that would be seen as the central bank being ready to bail out financial markets whenever they are in trouble and could sow the seeds for bigger financial turmoil/crisis by encouraging uncontrolled risk-taking.

The critical difference, though, is the BoE’s decision to provide liquidity support only at a penalty rate — a rate which is well above its official interest rate. The BoE’s policy rate is currently at 5.75 per cent and collateralised liquidity support will be available only at a premium over this policy rate. That is, the BoE has tried to moderate the “moral hazard” implicit in its provision of emergency liquidity support. (The end of last week saw a major UK mortgage lender officially availing of support from the BoE at a penal rate).

As against that, the Fed, on August 17, lowered the rate at which it provides collateralised liquidity support (the discount rate) from 6.25 per cent to 5.75 per cent and even made provisions for lending collateral to those institutions which lacked them. The Fed’s response to the liquidity crisis, therefore, even if it was a serious attempt to break away from the practice of the past couple of decades of providing an “implicit put option” for the market (a practice which was almost taken as axiomatic by the market), nevertheless was distilled enough to take account of the peculiarities obtaining in the US situation. Indeed, with the crisis originating in the US financial markets and given the scale/size of the affected markets in the US (the entire asset-backed securities market running into a couple of trillion dollars has come under a cloud dragging down along with it key short-term funding markets such as CPs), the Fed could possibly not afford to adopt a more rigorous (like the BoE) version of the approach than it actually followed.

Implications for India

A rate cut in the US (and possibly in other G-7 markets also down the line) in this environment holds significant implications for emerging markets such as India. We could either see a fresh flood of capital inflows which will complicate monetary and inflation management for the Reserve Bank of India. Note that M3 growth is still running ahead of RBI’s target despite a noticeable slowdown in bank credit. Or, there could be some pressure on asset markets (stocks, bonds, currencies) on the back of risk-aversion induced capital outflows. Oil prices could fall if the US economy slows down sharply.

On balance, though, it seems like we may see more rupee strength as the RBI could try to reinforce the trends towards lower headline inflation. Interest rates could likely remain stable (with a downward bias) for the next quarter though the chances of pronounced softening in first quarter 2008 are getting brighter by the day. Possible election-related government spending and high food prices though could be negative factors.

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