The US Federal Reserve has cut interest rates. And of course, I wanted to pontificate on this. But before that, lets answer a question that no one seems to have asked. Exactly what interest rates did the Federal Reserve cut anyway?
Federal Funds Rate –Overnight Targets?
The Federal Funds rate is the one over which all the hoopla is raised. Stripped off its jargon, it is the overnight interbank lending rate. As always, an example to explain.
Banks borrow and lend money everyday. In order to give money to withdrawing depositors, or to loan takers, they have to keep some cash which we will call daily cash requirement. The daily cash requirement is estimated by the bank at the beginning of each day. But at the end of the day, some banks have more money, and some banks have less money than they budgeted for. The banks that have more money can lend the money to the banks that don’t have enough overnight. Of course, banks charge interest. And it is this overnight interest rate that the federal reserve can control.
The overnight interest rate can be thought of as a penalty for banks that lend (give away) more money than they budgeted for. By lowering the penalty that the banks have to pay, Ben Bernanke and the Federal Reserve hopes to increase the lending amounts of banks, which leads to more money in the market.
Its November and all is not well!
The Markets (which is a nice way of saying Stockbrokers) expected the Federal Reserve to lower interest rates following rumours that the Sub-prime imbroglio had yet to run its course. The Fed did not disappoint in this. But what is interesting is reading the fine print in the text of their report.
The Fed says that they are rather worried about inflation, and don’t really have any plans of any further interest rate drops. With commodity and oil prices at all time highs, they believe that people are rapidly going to be faced with increasing costs on everything, from food to steel.
Why must the US Economy Grow?
Most economists expect that the United States Economy will not grow at all in this quarter, while the pessimistic types even expect a small contraction in the economy. But a question that can be asked is, “Why should the economy grow. After all, sometimes you have to be satisfied with what you have!” The answer to this is simple. If the United States population was constant, then there would be no real pain if there was no growth. It would be status quo, with the resources of the country being split equally amongst its people. However, with immigration, new births and everything else, the number of people in the United States of America is increasing. If the economy does not grow, a constant amount of resources will now have to be distributed across a larger number of people. This will make everyone (on average) a bit poorer. And this is NOT acceptable.
The problem of course is that this growth should be in real value. Its actually rather easy for the Fed to print more notes and make everyone richer. But the problem is that more money would be chasing after less resources. So the hard reality is that the Federal Reserve must increase production of goods(by encouraging investment) or must make it cheaper to import things (reduce import duties, Free trade and all that stuff).
Interest rates are one way to increase investment. And unfortunately for the Fed, its the only tool in its armoury at the moment. By lowering interest rates, they are hoping that people will be more inclined to invest in production/trade, thereby kickstarting the economic engine again.
But is it really needed?
That is a question where the answers are not quite so clear. The belief amongst most people is that the sub prime crises is a real dampener for the economy. However, I see that the whole housing market is only about 5% of US GDP. So is this 5% really going to drag down the remaining 95% down that badly?
The most popular answer is…YES. Like self fulfilling prophecies, the more people hear they are in trouble, the less willing they will be to spend and invest, which would drag down the whole economy. This is what the Fed is afraid of. And most people (laymen and economists) think that this is the reason why the Fed is lowering rates. Its to increase confidence.
A more scary reason!
But there could be another reason for the Fed to lower interest rates. And this is a much less comforting one. It has everything to do with capital movement across borders and the US Dollar.
Up to now, the United States has been running a whacking big trade deficit. This trade deficit is basically imports from other countries. They include oil, Software services from India and Chinese Toys. Ideally, imports should manage exports. So, in theory the Coca Cola that the US sells should make up for the Chinese toys. But this has not been happening. And it has not been happening for a VERY long time now.
The reality of the trade deficit
Its quite simple. Because it is importing more Chinese toys than its exports of Coca Cola, the US is giving away dollars to China (and the rest of the world). China (and the rest of the world) keeps these dollars in a special fund called a currency reserve. But if the US keeps doing this, the amount of dollars in the Currency reserves of countries will become so large that they might start asking uncomfortable questions like “What in Heck can we do with all these dollars that no one really wants to have? I would much rather have Chinese Yuan and Indian Rupees than dollars that the US is not going to take back”
What does the Fed lowering interest rates have to do with this? A lowering of interest rates actually increases the capital flow out of the US. More dollars flying away to be put in Indian and Chinese stock markets. But such huge flows of capital would put the currencies of these countries under immense pressure. A case in point is India, which has seen its currency rise over 10% in the last year. IF the Chinese Yuan were to appreciate similarly, in the long term, this would make Chinese exports to US less competitive, and will (hopefully) lower the trade imbalance between the two countries. At the same time, cheaper local interest rates in USA would mean that companies would be tempted to invest in business rather than merely hoard their money in savings deposits. So the domestic economy would be more inclined to grow, thereby making the USA a more resilient economy.
But….all this is contingent on the US citizen investing money rather than buying more Chinese toys. If he goes out to buy more Chinese toys with the money the banks are lending him, the capital flight out of the USA will only increase. And while the world economy would continue to grow, it will be interesting to see at what point the countries holding US dollars would start thinking of dumping them. And that would be an uncomfortable time for one and all
