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Saturday, September 22, 2007

The US Fed rate cut

Three perspectives on the US Fed rate cut

Distress in financial firms
It is feared that many financial firms are facing the threat of bankruptcy. This naturally prompts calls for help from the financial sector (e.g., here's a particularly shrill version). Most observers understand that rescuing financial firms triggers off a `moral hazard'. If financial firms know that they will be rescued when they take high risk and things go wrong, this will encourage them to be complacent about risk. As an example, Indian Bank was rescued, and it is hard for PSU banks to be closed down. Hence, every CEO of a PSU bank sleeps easily, knowing that bankruptcy is not a threat.
Economy-wide consequences of large-scale failure of financial firms
Ben Bernanke is famous for unraveling the links between endemic bank failure in the US in the 1930s and the Great Depression; he understands this issue very well. This motivates a role for the central bank to play the role of a lender of last resort - to stand ready to lend unlimited amounts to a wide variety of financial firms in a crisis, against good collateral, at penal interest rates. There is merit in such efforts on the part of central banks worldwide. It is careful to draw the line between the lender of last resort function of a central bank and outright bailouts where `zombie firms' are kept alive. The former is fine, the latter induces moral hazard, and as recent events in the UK show, it's not easy to draw the line.
The core business of inflation targeting
The third perspectives focuses on the core business of central banks, which is setting the short-term interest rate. Perhaps the greatest achievement of 20th century macroeconomics was the understanding, towards the end of the century, of inflation targeting. When a central bank stabilises inflation, this exerts a tremendous calming influence upon the business cycle. But the key ingredient is credibility. For inflation targeting to work its magic, the public has to believe that the central bank is serious about inflation targeting, and that inflation will not stray significantly from the publicly announced target.

Deconstructing the US Fed rate cut

Central banks in mature market economies have spent decades building credentials as inflation hawks. From 1979 onwards, the US Federal Reserve has become a de facto inflation targeting central bank. The really difficult question about the present situation is: By cutting rates, is the Fed igniting inflation, and risking the loss of this hard-won credibility that has been build up by the two preceding Fed chairmen?

In my mind, an important difference between the Bank of England, as opposed to the US Fed, lies in de jure versus de facto inflation targeting. In the UK, decision makers have to worry less about the credibility of inflation targeting because it's written into the law. In the US, decision makers know that the law predates modern monetary economics. It's only by force of sheer will that Messrs. Volcker followed by Greenspan have shifted the country to inflation targeting.

Bernanke eloquently defends the de facto inflation targeting regime, saying that while the law asks for a pursuit of both low unemployment and low inflation, the only way to get low unemployment on a sustained basis is to do inflation targeting. He's right, of course, but many politicians might see this differently. As Greenspan has been emphasising in recent weeks, there are legitimate concerns about whether the US Fed will be able to hang on to this course in the years and decades to come [Mark Gilbert].

The Fed has to worry about two scenarios. On one hand, the conditions in the housing market in the US are very bad, and these could tip the economy into a recession [Feldstein]. In this case, inflation will drop in the future, and a rate cut today is appropriate as part of running an inflation targeting monetary rule. Fred Mishkin has recently emphasised the importance of a monetary policy response before large output losses are visible owing to the housing crash. John Mauldin's newsletter has a good treatment of this. On the other hand, the US economy is extremely resilient, with a rapid switching of workers from one firm to another or one sector to another. The economy could be on its way to bouncing back, in which case the rate cut could endup igniting inflation. The essence of the decision of the US Fed lay in making a call between these two scenarios.

The trouble is that the best economic models of inflation are not very good in helping to choose between these two scenarios [Lucas]. Bernanke and Co. have made a call. Time will tell whether it was the right one. The early evidence suggests that the Fed decision has stoked inflationary expectations.

The key point about their thought process is that Ben Bernanke, and everyone else involved in the decision making, are very conscious of the hard-won post-1979 track record of the US Fed as being an inflation targeting central bank, despite an outdated legal framework. They would be loath to squander this credibility. In other words, if they have decided to cut rates, it must mean that in their judgment, things are really bad in the US economy.

Herein lies the conundrum. Financial markets seem to think that the rate cut is good news. But when we deconstruct the Fed decision, it seems to be predicated on a gloomy assessment.

Why is the equity market so optimistic?

Why is the equity market so optimistic when Bernanke and his colleagues, who are arguably the smartest and best-informed analysts of the world economy, are not? Do financial markets over-estimate the power of monetary policy.

Optimism about conquering the impending downturn is expressed through the analogy with the success of the US Fed in 2001. That success story should be tempered by three caveats:

  1. When the 9/11 attacks took place, the Fed got a uniquely clear real-time signal about impending distress. On 12 September 2001, it was crystal clear that there was a problem. In contrast, in a normal times, no such clear data is available; a downturn is only known with a lag of many months owing to weaknesses of the statistical system.
  2. After the 9/11 attacks, the downturn in the US was aggressively tackled with both monetary and fiscal policy. Not only were interest rates cut in the US; tax rates were also cut and the massive expenses of fighting two wars began. Monetary policy should not get all the credit for rescuing the economy.
  3. Finally, as Nouriel Roubini emphasises, the aggressive easing of monetary policy in 2001 did not eliminate the downturn. There was a full half year of negative GDP growth in the US.

In other words, even with a modern inflation-targeting central bank, operating with supernormal information, with rare synchronisation with fiscal policy, the business cycle has not been conquered. Conditions in 2007 are surely less benign.

One difficulty lies in the demographic composition of participants in the financial markets. Inflation targeting by the world's key central banks has worked so well from 1979 onwards, that most people in financial markets have never experienced a serious recession. They may be prone to understating the business cycle.

Financial market participants are very effective at pricing and arbitrage involving one instrument at a time. But they seem to find it difficult to grapple with macroeconomic complexity, where there are many moving parts interacting in a complex way. From 2002 onwards, there has been a gulf between the perception of the economists and the markets on the `global imbalances', and particularly the co-dependence of China and the US. Many wise macroeconomists expected a complex adjustment process with many uncertainties. Financial market practitioners were sunny and optimistic. So far, the macroeconomists are ahead.

An Indian perspective

India is much more globalised these days; what happens in the US economy matters greatly to us [Ila Patnaik]. In India, RBI has weak credentials on fighting inflation. Every now and then, it surreptitiously sets about pumping liquidity into the local economy in chasing exchange rate targets, which ignites inflation.

If RBI continues to run a pegged exchange rate regime, it focuses on the clerical function of ensuring that the rupee-dollar rate does not move, and Bernanke is our central banker. When Bernanke cuts rates, capital is likely to flow into India and thus generate excessive liquidity here, thus igniting inflation. This is not in India's interests, given where India is in the business cycle. India does not have a problem of a housing market which is in deep distress; India's problem lies in having stubborn inflation that needs to be vanquished.

The most important task, in coming months, lies in insulating India from the US Fed's monetary policy. We need to establish Y V Reddy as our central banker and not Ben Bernanke. There are many uncertainties in how things will play out. Capital flows could surge into the country, in response to the falling dollar, or they could reverse themselves if there is a global flight to safety. In either case, RBI needs to refrain from trading in the currency market; it must not run a pegged exchange rate. If it is able to do this, then the currency market could actually be a shock absorber that will shield the economy from global fluctuations and US monetary policy.

If, on the other hand, RBI focuses on the exchange rate, then we are in for an unpredictable ride where decisions made by Bernanke, based on concerns of US citizens, shapes the lives of Indian citizens.


  1. Ajay
    I thought the RBI stopped intervening in the forex market since April 07.This led to a sudden dip in INR inflation and a massive rupee appreciation.So why are you saying that the RBI should stop intervening?.Haven't they already stopped?.

    Have they re-started it?.Clearly I'm missing something..pls elucidate
    Thanks Vivek

  2. Anonymous Vivek,

    There was no announcement from RBI about what the exchange rate regime was or is. So de jure, nothing changed.

    The INR/USD rate moved significantly from 15 March to 6 April. Currency trading data is not released at a weekly or a daily frequency. What we know is this:

    Feb 11.86B
    Mar 2.31B
    Apr 2.06B
    May 4.43B
    Jun 3.19B
    Jul ~11.5B.

    Data for August or September are not released just yet.

    In short, you don't know what they're doing.

  3. Hi Ajay

    I am avid follower of ur blogs. I came across this article on MSN money citing Satyajit Das:

    Is sky really falling ?

    I am interested to read ur experts comment on this topic.


  4. Do you think as a developing economy we should have a free floating currency rather than a managed float since the currency would be more volatile when these capital flows come in and out of the economy thus no stability to the rupee.Most of the south asian economies have pegged their currency to the dollar and don't have a cur a/c deficit either - What do you think is the way ahead sir?

  5. What an interesting topic. Kevin Price also wrote about the fed desicion. Check out his blog at

  6. Hi Ajay,

    An interesting post indeed. I have a few questions.

    1. Do you think Bernanke is really an 'Inflation Fighting Fed' or is he more deflation frightened Fed? Thanks to his famous Helicopter speech in 2002?

    2. Did Bernanke acted as a lender of Last Resort when the Discount Window rate was cut twice and the timing of that was somewhat 'interesting'?

    3. If RBI does not intervene in the dollar inflows (which even I honestly believe, they should not), wouldn't it turn out that - Bernanke will end up becoming our central banker? For what happens will be decided by 'copious' (pun intended) inflows? What should RBI do? Should they resort to 'Capital Controls' or should they let 'Market decide what is right'? For if they choose later, isn't it possible that the capital inflows that are chasing India today will leave one day for sure ('cos thats the nature of such capital flows.) and what would we be doing if our currency goes for a toss then?

    5. Isn't it true that appreciating rupee will certainly have cascading effects on our economy on the downside?


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