The recent, higher than expected, 50 basis points hike in the benchmark federal funds rate, by the US Federal Reserve, has been the focus of endless analysis and discussion. This rate is what the banks charge each other for overnight loans. This cut in interest rates will reduce the cost of borrowing, and is thereby expected to ease the credit squeeze and sustain consumer spending.
A brief history of the recent US interest rate changes is instructive. The latest rate cut is the first interest rate cut for more than four years. Alan Greenspan's Fed had cut the interest rates to a 40 year low of 1% in June 2003, in efforts to stave off recessionary trends and stoke investment and consumption growth. The rate remained at this low of 1% for a year, till June 2004, when the Fed started hiking rates to put the brakes on a booming economy. There were 17 consecutive 25 basis points hikes till mid-2006, as the Fed grappled with trying to keep a lid on inflationary pressures thrown up by the rapidly overheating economy, spurred on by a borrowings driven housing and consumption boom. However, since the last rate hike in mid-2006, the rates have been kept unchanged at 5.25%.
In January 2001, the Fed started a series of 11 consecutive rate cuts, bringing the rates down precipitously from 6.5% to 1.75% over a period of 11 months, as the US economy stared at imminent recession. By November, 2001, the recessionary fears eased and the Fed eased off its foot from the monetary policy pedal.
Alan Greenspan spoke many times of "measured" changes in the interest rates, so as to influence economic growth without simultaneously creating inflationary expectations. This can be seen in the 11 consecutive rate cuts of 2001, and the 17 consecutive 25 basis points hikes of 2004-06, in response to recessionary and inflationary trends. In both cases, Greenspan argued that the small rate changes, helped the Fed respond to the situation as the economy moved forward. It was felt that forecasting the medium term outlook in such unpredictable times was impossible, and hence the more wiser course of action was to adjust monetary policy in response to the immediate future.
It has been normal practice for Central Banks to adopt the wait-and-watch attitude and then respond with regular and small rate changes. The US Federal Reserve has been adopting this strategy in recent years, and Central Banks elsewhere have been imitating this strategy. While giving the Central Bank an apparent freedom and ability to control the immediate financial environment, such small and recurrent rate changes, tend to be adhoc and reactive, thereby missing the big picture. While bringing short-term relief and calm, such tinkering does little to reduce the medium-term uncertainty nor mitigate risks. There is one school of thought which in contrast, argues for fewer, and larger rate changes, which tend to give a clear indication of the policy being pursued by the Central Bank. This clarity feeds more certain and assured expectations among investors, thereby reducing uncertainty and risks. It tries to reduce the information assymmetry and thereby channelize expectations and mitigate risks.
The last Fed rate cut took the markets by surprise, in the extent of the reduction. The 50 basis points was a clear expression of the Federal Reserve's commitment to try everything possible to stave off any financial crisis, arising due to the sub-prime mortgage defaults. It was a firm and unambiguous step towards easing any liquidity crunch. The markets got the message, and responded accordingly. The stock markets, both in the developed and the emerging economies, have been soaring ever since. It would be instructive as to what would have been the market response to a smaller rate cut, of say, 25 basis points. On the flip side, the higher than expected rate cut bonanza may have encouraged further "irrational exuberance" in the financial markets! The supposed cure may have inadvertantly worsened the disease.
There is another less discussed dimension to this debate about interest rates. It is widely perceived that lowering interest rates would help spur investment and prevent the US economy from slipping into recession, and also stabilize the sub-prime panic hit financial markets. While the latter may be true, the former reason is not as simple as is being made out.
Interest rates were consistently above 5%, touching even 7%, in the high growth Clinton years of 1993-2000, when the real economy enjoyed its best years. In fact the performance of manufacturing and services was much better during this period than in the first half of this decade, which was marked by historically low interest rates. The investment rates rose from a low of 17.8% of GDP in 1993 to a high of 20.80% of GDP in 2000, during the period of high interest rates. So it would appear that all the talk of high rates affecting investment and the real economy would appear not borne out by facts.
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