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Why the US rate cut may kill the dollar

The recent cut in the benchmark interest rates by the US Federal Reserve by 75 basis points from 4.25 per cent to 3.50 per cent on January 22 and a further 50 basis points to 3 per cent on January 30 as a response to a possible recession in the United States has completely surprised analysts across the world.

Unprecedented as it is, this steep cut in the interest rates effected by the Fed has the potential to dynamite the US dollar, the US economy and, by extension, the global economy.

What could surprise many is the fact that the US Fed's prescription to reduce interest rates, ostensibly to tackle the prospect of a recession might well turn out to be its Waterloo. Put bluntly, the US faces as much of a risk of a recession after this rate cut as it did before.

Two economists end up usually giving rise to three opinions. Nevertheless, most of them are near unanimous in their view that the situation in the US economy is quite serious. In fact, many experts are veering to the view that the US economy -- the engine of the world economic growth -- is well and truly into recession.

What is increasingly viewed as conclusive proof of a recession within the US is that the US Fed cut interest rates on three occasions in the second half of 2007 aggregating to 100 basis points, prior to this cut of 125 basis points in January 2008. All these are alarming signs indeed.

Breather for (sub-prime) borrowers?
Ostensibly this cut is aimed at alleviating the worst housing recession in the US since 1991 and ease the pressure on the economy. The situation is so appalling that some US lawmakers had even called for cheaper borrowing costs for the benefit of the average Americans (and you thought that such silly demands could be made only by our desi politicians).

And this cut is aimed at providing succour to all those stakeholders -- borrowers and lenders -- who were party to this credit extravaganza for the past several years. It may be noted that it is this credit expansion in the US that acted as a de-facto compressor for the above mentioned engine of global economic growth.

And it is not a problem that pertains only to sub-prime borrowers, as is commonly believed. As many credit card, car and consumer loans too are beginning to turn bad, the US financial sector is facing a crisis of an unprecedented magnitude.

Consequently, with many banks and financial institutions facing prospects of going belly up, the Fed had no other option but to cut interest rates. For, if it hadn't effected a rate-cut, it would have triggered a severe crisis within the US financial sector over the next few months and might have led to the collapse of many financial institutions.

But will it solve the problem?
Apparently, by cutting interest rates the US Fed expects to stimulate consumption, crucially lower mortgage payments, and in the process trigger a recovery in the US economy. Be that as it may, top economists -- including Noble Laureate Joseph Stiglitz -- point out to the futility of this exercise saying that this cut in interest rates will have little impact on the overall scenario.

According to them, it is a case of too little and too late -- akin to applying pain balm when chemotherapy was the need of the hour.

Even as the interest rate cuts are carried out experts believe that US Fed chairman Ben Bernanke may be open to the charge of creating 'moral hazard.' After all, in sum and substance, the act of the Fed is rewarding all those who were party to reckless borrowings and lending.

As US lowers its interest rates dramatically, economists are worried that it could find that global capital is moving away to other countries which offer higher rates of interest simply on account of arbitrage opportunities. This could mean appreciation of currencies across continents and depreciation of the US dollar. As the dollar depreciates against other currencies, goods from other countries would become costlier in the US, leading to inflationary pressures within the US economy.

According Allan Meltzer, a Fed historian, the Fed "put all of its chips on the prospect of a possible recession, and very little on the possibility of inflation." And should the US be visited by a bout of inflation, as predicted, the Fed would have no other option but to once again increase interest rates. And that could be an unmitigated disaster.

What could worry the US economists is that years of sustained imports of 'cheap' goods -- ostensibly aimed at controlling domestic inflation -- meant ignoring the competitiveness of the domestic manufacturing sector in the US. It may be noted that this model also suited developing nations as it provided cheap manufactured products to them, made cheaper through a strong dollar. But all good times have to come to end, right?

American economist Robert Blecker has examined the impact of the extant currency valuation arrangement between the US and other currencies on the US manufacturing investment spending. He estimates that under this paradigm the US manufacturing investment was lowered by 61 per cent between 1995 and 2004. This has structurally and systematically weakened the US industrial base making imports inevitable to meet the gargantuan domestic consumption.

Further, it also makes the future task of developing a competitive domestic manufacturing base within the US in the next few years an exercise in futility. Given a weak-manufacturing base in the US and the extent of dependency on imports to meet domestic demand, it is quite probable that any further depreciation of the dollar could stoke inflation in the US. And that could be a trigger for higher interest rates.

But will it lead to a collapse of the dollar?
But inflation within the US is not the only issue that bothers economists. What complicates the entire matrix is that the US is dependent on global capital flows of approximately $900 billion in 2007 to sustain its economy. With global inflation untamed and central bankers of other countries having virtually exhausted every other policy option to deal with inflation, interest rates are at a high across continents.

Naturally, none of the central bankers of other economies are in any mood to cut interest rates in tandem with the Fed.

Consequently, it is feared by many economists that this steep interest rate cut effected by the Fed would trigger currency readjustments. This would be particularly sharp should different economies fail to lower their domestic interest rates.

It is thus no wonder that the dollar is going the Titanic way against the other currencies even as I write this. Similarly, given this paradigm of interest rate differential prevailing between the US and India, the Rupee which had posted handsome gains against the dollar in recent months too is expected to appreciate further in coming months.

Naturally, the Reserve Bank of India [Get Quote] is caught in this predicament. As global capital finds its way to India because of higher interest rates here, RBI would increasingly be 'forced' to cut interest rates. If it does not, the deluge of foreign exchange flows would lead to a corresponding increase in Rupee circulation within the economy and thereby lead to higher inflation and still higher interest rates.

But with an overhang of liquidity and domestic inflationary pressures caused due to a multiplicity of local factors, lowering interest rates is not a preferred policy option. No wonder the RBI was reluctant to cut interest rates while undertaking the latest review of the Credit Policy on January 29. Surely, a Catch-22 situation for RBI.

Given this scenario, as (stock) markets realise these intrinsic dangers arising out of interest rate cuts initiated by the US Fed, they are sure to witness some correction.

No wonder markets the world over are already feeling exhausted within days of the Fed announcing the moves. Where is the question of comparing or analysing the quantum of risks, returns and rewards when the principle itself is in doubt? This is one question that seems to have come back to haunt market players as they understand the mess in all its dimensions.

For all these reasons the interest rate cuts may not work and Fed's game plan could well be condemned. And that is the crux of the issue -- the US economy would have collapsed had the Fed not cut the interest rates and as it cuts the interest rates it could endanger the dollar and cause its collapse.

Needless to emphasise, the beneficiary of the rate cuts are the stock markets and not the US economy as a whole as is commonly believed.

So what was the compulsion for the Federal Reserve to take this gamble? Why protecting the US stock markets became more important that anything else for the Fed Reserve? Is the US stock market more precious than the US dollar? Is bailing out the reckless lenders and borrowers more important than controlling inflation in US?

Questions that are too crucial and the answers to these questions may well determine the fate of the global economy in the next few moths.

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Last modified on Sunday, 07 July 2013 07:36