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Ever since the US credit crisis broke out in August last year, the US Federal Reserve has been on a rate-cutting spree, slashing the Fed Funds rate six times, from 5.25 per cent on Sept 18 to its current level of 2.25 per cent. Since January alone, when the crisis intensified, the Fed has cut rates by a total of two percentage points.

It is widely believed that Fed chairman Ben Bernanke and his colleagues on the Federal Open Market Committee - the Fed’s rate-setting body - are now at the tail end of their current rate cutting cycle; the consensus view is that at today’s meeting, they will enact the seventh and last of the rate cuts, by 25 basis points, bringing the Fed funds rate to 2 per cent. A minority of economists however expect them to continue cutting, with some projecting that the Fed Funds rate could go as low as one per cent by the end of June.

The precarious state of the US economy has no doubt greatly complicated the task of monetary policy. On the one hand, there is a seriously weakening economy: Mr Bernanke has acknowledged that real GDP will not grow much, if at all, over the first half of 2008 and could even contract slightly. The IMF has indicated that the US will experience a recession during the twelve months from the fourth quarter of 2007. Indeed, several economists claim that the economy is already in recession, and soon enough the numbers will confirm it.

However, on the other hand, inflation - which the Fed is also mandated to control - is headed up, fuelled partly by soaring commodity prices. The IMF projects US consumer price inflation at 3 per cent this year, which means that the real rate of interest for the Fed funds rate is now negative - which is not good for inflation control.

Moreover, such low rates contribute to a decline in the US dollar - especially against the euro, which is underpinned by rates at 4 per cent. The decline of the dollar in turn drives commodity prices further up, which feeds back into still higher inflation. In such a spiralling situation, further rate cuts at this point would be risky. There is thus much merit in the Fed interrupting its rate cutting cycle. The need to allow previous rate reductions to work their way through the system underlines the case for a pause. In addition, the Fed needs to leave itself with some room for possible future cuts as well, even this year.

For it is clear that the weakness of the US economy - and in particular its housing market - still has a long way to go. And while the prospect of a systemic financial meltdown has probably passed, we have yet to see how the US financial system copes with a recessionary economy. If the recession is severe, the impact will be magnified, and further rate cuts may yet be needed.

Thus, even if the Fed does signal a break from rate cutting, it would be premature to suggest that US rates have bottomed out. Likewise for the US dollar. Which means that high commodity prices too, and thus inflation, will be with us for some time yet.

Source : Business Times - 30 Apr 2008