Saturday, February 2, 2008

Opinion on Fed slashes rates to halt sell-off

For a class paper:

My initial reaction to the article, “Fed slashes rates to halt sell-off” by Krishna Guha and Michael Mackenzie published on January 23, 2008 was of unpleasant unease and surprise. Although it is not alarming that the US economy is facing many difficulties including the sub-prime fallout, credit crunch, declining stock market, depreciating dollar, inflation concerns, and the strong possibility of a recession, I am surprised it took this course of action. I had not appreciated the magnitude of the threat or the severity of the US economic condition. Only in dire circumstances would the Fed, the central bank of the capitalist “let-the-market-decide” world, make such a drastic decision to affect the open markets. This has many implications for the US and the world economies.

In the US, Traders’ reactions were similar to mine. This emergency announcement which was made before the planned announcement on January 30th created a major reaction in the US financial markets. The reason was it was a big move. It was the first unscheduled Fed rate cut since September 2001 and the largest single cut since August 1982. Under semi-strong form market efficiency, this was new public information which caused Wall Street indices to open nearly down 4%. I believe investors were not entirely unsure of what this information meant. One implication was that the economic condition was worse than they once believed, which caused the market to plunge in early trading. Investors are always looking for more information and one of the most informed sources is the Federal Reserve whose purpose is to monitor and guide the US economy. The Rational Expectations Theory suggests government policy can not influence the decisions of people in the economy if anticipated. Clearly, this was not anticipated. On the other hand, it also hints at more cuts to come and gives the sense that Fed would keep the economy afloat with its aggressive policies.

I think this measure was needed to send a strong but not panicked message to investors. On the policy side, the Fed really does need to overcompensate for its lack of tight monetary policy during the previous quarters of high growth of and inaction during the high risk credit gambles. Only recently, has the Fed started putting in regulations for high risk lending. However, I do find it unfortunate that they are now shifting their goal from inflation targeting to economy saving. As economists, many believe keeping inflation low is the number one concern.

On the other hand, I know how vital it is to keep the US economy from a recession. When the US economy is shaky, the world economy is shaky because the US economy is such a force in the global economy and the world is more interdependent than ever. Investors still remember the Asian Financial Crisis which involved the US bailing out many emerging economies. Now it’s their turn; however it will be harder to bail out the largest economy in the world. The world is intently watching how the Fed and the US government try to resolve this economic mess. It seems they are trying everything possible. The US currency has depreciated to local lows allowing for a more advantageous balance of trade. Foreign countries are injecting capital into the US by buying stake in US financial companies such as Citigroup and Merrill Lynch which are in poor conditions after having suffered billions in losses due to their high risk bets and involvement in the subprime mortgage crisis. Citigroup raised $14.5bn and Merrill $6.6bn from private investors and governments in Middle East and Asia, but they’re not enough to soothe investors. I believe the Fed is doing the right thing by keeping the US from going into a recession.

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