The first cut was on January 3, both the Fed Funds and the Discount rate; the second was January 4, the Discount rate; and the third was January 31, both the Fed Funds and the Discount rate. The January 3 and 4 announcements were unusual in that they occurred immediately after the New Year’s Holiday and were not part of a regular FOMC meeting. Prior to this latest rate cut, the Fed made it a point to announce that they were holding a two-day meeting to decide on their actions, when typically their deliberations are much shorter.
We think the cumulative cut of one percentage point in less than 30 days signals an economy that is already in a deep recession. In our January 15 StratAlert, we predicted that the Fed would pass on a rate cut at the end of this month, with the expectation that they would cut rates again in February. While we recognize that the economy is slowing, we did not think that the situation was alarming. Following the Fed’s surprising move on January 3, we concluded that the economy was much softer in the fourth quarter of last year than what we thought. Consequently, we changed our fourth quarter GDP growth projection to 0.6 percent, from our earlier expectation of 1 to 2 percent growth. We assumed that the Fed had data indicative of a more serious slump. After all, the Fed does have access to some information, before it is released to the market. However, the fourth quarter preliminary estimate, released by the Commerce Department on January 31, showed a better than expected 1.4 percent growth. Was the Fed really expecting a flat economy in the fourth quarter?
As we stated in our earlier StratAlert, the Fed’s decisions seem influenced by market sentiment. Perhaps they are reacting more to market psychology than to actual economic data. They could also be bowing to market pressures. The securities industry and the investment community are highly desirous of lower rates, as this will push up the value of financial assets. Few days before the January 31 FOMC meeting, stock market insiders were saying that the Fed had to cut interest rates by at least 50 basis points, because the markets were already taking it for granted. Whatever the circumstances, playing to market sentiment could backfire, and also increases the risk of inflationary pressures, specially if a large cut in rates sparks a surge in consumer spending.
The Fed’s FOMC statement raises several questions. It mentions the erosion of consumer confidence and a sharp fall in manufacturing and it goes on to say that "these circumstances have called for a rapid and forceful response of monetary policy". Yet, the industrial production index declined by 0.6 percent last December, and the manufacturing component by 1.1 percent, these are not sharp cuts. It is true that consumer confidence has eroded considerably. In fact, the Conference Board index for January showed a plunge of 14 points in January. However, the intense controversy regarding the outcome of the Presidential elections did have a temporary dampening effect on consumer sentiment. Too forceful an action, on the part of the Fed, could scare consumers into a spending freeze. America’s factories and services firms are indeed coping with a slowdown in demand. However, a rate cut is not going to spike consumer spending overnight.
There are significant risks in the Fed’s actions, mostly because the economy is in a very difficult stage. Only one thing is clear, the expansion cycle is over, and the economy is slowing, but at this point, the indicators are giving mixed signals regarding the pace of the slowdown. For the first time in about ten years, the Fed hits rough waters with dangerous cross-currents. Is the economy already in a recession, as their actions imply? If not, then the severity of those actions could very well trigger one, by scaring people. Or the latest Fed induced surge in liquidity could fuel the fires of inflation.
The Fed’s actions could risk higher inflation and a lower dollar. As we have said in previous StratAlerts, inflation is a stubborn problem. The "trend" inflation rate is currently at an annual rate of 3.3 percent (as we have explained in the past, we use a moving average of inflation, since the "core" rate is a misleading indicator). The latest interest rates cuts could inject more liquidity into the economy, which could result in higher inflation. At the same time, the dollar has been weakening with respect to the Euro in recent months. The current account deficit reached an unsustainable 4.7 percent of GDP last year. Our sizeable fiscal surplus is dwarfed by our external sector deficit. A growing trade deficit is not good for the dollar. And if the dollar depreciates, our import costs begin to climb.
Based on a worst case scenario, interest rates cuts could worsen our economic outlook. This could happen if after lowering interest rates, demand fails to pick up sufficiently, because consumers are scared, but not too scared to refinance their mortgages. Thus inflation does not decline or actually accelerates. Or perhaps demand does pick up, and this translates into higher inflation and a larger external deficit. Higher inflation could then trigger a depreciation of the dollar and a larger trade deficit. A lower value for the dollar would in turn add to inflationary pressures. In that case, the economy would fall into a vicious cycle, possibly "stagflation."
A final word of caution. Several years ago, the Fed decided to give markets more information, regarding policy direction, in the press releases after the FOMC meetings. When the markets began giving differing interpretations to these statements, they stopped the practice. Now that the Fed seems to be emphasizing the psychological impact of their actions, the markets and consumers could interpret those actions in a way not intended by the Fed. The strategy of monetary policy may be appropriate, but the tactics could backfire when the economy is at difficult crossroads.
Some Comments on the Impact of the Rate Cuts and possible US Recession on Latin America.
The slowdown in the U.S. economy, and the possibility of a recession will have significant impact on the performance of the Latin American and Caribbean economies. However, a slower U.S. economy will impact the economies of the region in different ways, depending on the importance of international trade and their level of external debt.There will be a positive effect. The interest rate cuts will alleviate the external debt servicing burden and will allow greater flexibility in financing their external and budget deficits on more favorable terms. The major Latin American economies will take the opportunity to float large bond issues. As a matter of fact, Argentina and Brazil are already leading the way. Banks and corporations will also take advantage of lower rates to obtain loans for domestic investment. Lower interest rates in the U.S. give regional governments more room to maneuver, since the pressure to maintain a differential between U.S. and domestic rates, and to attract investors, will subside. As a result, domestic interest rates could also be cut, to boost economic activity and employment.
The negative effect, stemming from sagging U.S. demand, could offset the benefits from lower interest rates, particularly in terms of production and employment. We must remember that the U.S. is the main export market for Latin America and the Caribbean. If the U.S. consumer retrenches, Mexico, Central America and the Caribbean, will feel the brunt of the impact. Those countries are major suppliers of goods to the U.S., through the so called maquila operations. To the extent that countries such as Brazil and Chile also depend on trade with Asia and Europe, the slowdown in the U.S. will be less pronounced. Nevertheless, as the U.S. slows, it will eventually affect growth in Asia and Europe, and thus Latin America.
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