Tuesday, June 24, 2008

Why the Fed should not raise rates now?

What should Ben Bernanke do with the American interest rates? The American economy is facing the twin pressures of the aftermath of the sub-prime mortgage crisis and the rising global commodity and energy prices. Atleast by some estimates, the US economy may already be into a recession, and most macroeconomic parameters are showing clear signs of a downturn. Interest rates are at historic lows, and real rates are in negative territory.

In the circumstances, it appears that the prudent strategy for the Federal Reaserve would be to desist from raising rates in the medium term and focus its attention on reviving the economy and bringing about a soft landing, than targetting inflation.

Here are the four reasons why the Fed should not raise rates

1. The sub-prime mortgage bubble is far from over. The Fed's proactive intervention by way of the Term Auction Facility (TAF) and relaxing credit standards, have had the effect of reassuring the market and squeezing out some of the excesses. It has helped ease the short-term liquidity problems faced by Wall Street and brought valuable time for these financial institutions to reschedule, write down and get their books into some shape. But is estimated that so far, only around a small portion of the bad loans on their balance sheets have been adequately addressed.

Beyond cosmetic tinkering, these measures have done little to address the deeper issue of solvency that bedevils the American financial system. It is estimated that even many of the prime mortgages might come under threat if the housing market continues to drop. The tumbling real estate market has led to many home owners ending up holding debts which outsize the value of their homes. And as the Case Shiller index shows, the fall in home values continue unabated.

Any rate hike now will have a knock-on effect on all these mortgages, raising the cost of servicing the debt. The home owners will find their debt service costs going up, opening up the possibility (even certainty) of more foreclosures. This in turn will adversely affect the mortgage holders and their insurers, leading to further defaults and writedowns. Further, any deepening of the crisis on Wall Street will soon find its way to Main Street. So it is understandable that if Wall Street sneezes, credit dries up and Main Street catches cold.

2. The real economy is precariously perched, facing the possibility of entering a recession (if it has already not entered one!). The "negative wealth effect" from the sub-prime driven credit squeeze and falling home values have led to sharp declines in consumption spending, which was the engine that drove the sustained high growth rates of the nineties and first half of this decade. These problems have now been exacerbated by the rising commodity and energy prices. With the uncertainty and a recession looming large, gross private domestic investment has been falling for successive quarters and the investment climate is not encouraging.

With elections coming up later in the year, the Federal Government has responded with a $145 bn fiscal stimulus to prop up the declining demand and sustain growth. This fiscal stimulus is now underway, and this should be given a chance to play itself out and sustain growth till the excesses in the financial system are wrung out and investment climate improves.

Further, with profits squeezed by a consumer slowdown and soaring commodity and energy prices, companies have been reluctant to hire, thereby driving increase in unemployment rates by its fastest pace in more than two decades. With confidence in the economy dipping at an alarming rate, any further bad news on the unemployment front will be politically suicidal in an election year. The higher rates will only add to the cost pressures being faced by the corporate sector.

In this context, it may be instructive to recall the example of Japan in the later years of the nineties. The Japanese Government reeling under a liquidity trap had resorted to reflating the economy by massive pump priming investments in infrastructure. When the economy was just about looking up in late 1998 after a decade long slump, the Central Bank raised rates thereby killing off the nascent recovery signs. This confined the economy to another 5-6 years of recessionary pain.

3. The US dollar has been on a continuous decline against all the major currencies. But this has helped the American imports and has contributed to a drop in the US current account deficit and addressing external balance distortions. In such uncertain and difficult times as now, a declining dollar will help to maintain growth and employment by raising exports and causing American consumers to shift their spending from imports to domestically produced goods and services.

The low interest rates have had the effect of making investments in US T Bonds unattractive and has led to many Asian Central Banks searching for alternative avenues for investing their growing surpluses. Any rise in the rates now will only increase the yields for US T Bonds and draw in more Asian forex surpluses, thereby putting upward pressure on the dollar.

4. Though inflation is fast emerging as a major problem, it is driven by supply side constraints which are mostly outside the control of the US or any other individual national government. In fact, many analysts are of the view that inflation is being driven mainly by the rising oil prices.

Further, consumer spending and private investment are falling, thereby limiting demand side inflationary pressures. Under such circumstances, monetary policy is likely to have limited effect in containing inflationary expectations. Also, even by historical standards, for an economy standing at the footsteps of a recession, the inflation rate remains fairly benign.

The low rates should continue for some more time so that the financial markets are given adequate time to squeeze out and write down the major portion of the excesses built up during the sub-prime mortgage bubble and the housing market regains some stability. This opportunity should also be used to rectify the external account imbalances and bring down the current account deficit. It will also enable the American consumers to save more and pull up their domestic savings rate from its present negative territory.

Interestingly, the decoupling debate may have a more meaningful resonance in the context of monetary policy now. Even as the China and India led emerging economies may need to raise their interest rates so as to contain runaway inflationary pressures and even cool down their overheating economies, the US may actually need to keep rates low so as to prevent the economy from crashing hard into a deep recession.

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