US Fed takes decisive action

The US Federal Reserve Board has shocked global financial markets by cutting the Fed funds and discount rates by 75 basis points to 3.5 and 4.0 per cent respectively. The drastic cuts were announced an hour before US financial markets opened on Tuesday. Equity prices have been shored up worldwide as a result, after days of taking a battering. The timing of the cuts was unusual because the Fed will hold its next meeting on January 29 and 30. Normally, the Fed does not announce cuts in the inter-meeting period for fear it could send out panic signals. The cuts this time mark the first inter-meeting action since September 2001 and are the biggest since the early 1980s.

We believe the Fed must have seen some black holes in the financial system, rapid deterioration in the financial markets as well as looming economic recession, which prompted it to take action before confidence evaporated. Indeed, several economic houses have predicted a US recession this year. UBS Research Economics, for instance, predicted on Tuesday a recession of less-than-average severity. The US GDP growth is expected to register -1.0 per cent in the first quarter and -1.50 per cent in the second quarter of 2008.

Has the Fed acted too aggressively? A cut of 75 basis points is definitely aggressive but is also justified, given the current housing deflation and credit crunch. Without the Fed's action, Asian markets would have taken a serious beating. In the week up to January 22, the Indonesian market fell 17 per cent, compared to 10 per cent for the Malaysian market, 13 per cent for the Philippines, 9 per cent for Singapore and 4.9 per cent for the Thai market.

If we look a week ahead, we can expect the Fed to take further action by cutting the interest rate equally sharply. Already the Fed has signalled this: "While strains in the short-term funding markets have eased somewhat, broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labour markets ... Appreciable downside risks to growth remain. The committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks."

Some economic research houses have predicted the Fed will cut another 50 basis points on January 30 at its regular meeting to boost the US economy and financial markets further. President Bush's announcement of a stimulus package of US$140 billion last week had failed to impress the markets. We now see both the White House and the Fed acting in concert to remedy the deteriorating economic and financial conditions.

Several US financial institutions have faced distress due to their exposure to the sub-prime mortgage crisis. They are badly in need of fresh capital to shore up their balance sheets. So far sovereign funds from the Middle East and Asia have stepped in to inject capital into the US banks and investment houses. Others might need a bailout from the US Fed. What we have witnessed in the US sub-prime is only an overture of a more serious outlook that will unravel over coming months.

How should the Thai authorities respond to the Fed's cuts? Before, the banking authorities had kept the benchmark rate on hold, as they watched inflation and energy prices closely. Inflation was a serious threat because Thailand is vulnerable to oil price rises. The Thai authorities had been preparing for a cycle of monetary tightening in order to allow a more stable path for growth.

But with the Fed's action, Thai authorities might have to change their stance. Now they are taking a hard look at economic growth prospects more than inflation risks. A US recession means oil prices might have to come down due to sluggish demand. If Thai growth were to slacken, it might be necessary to loosen monetary supply to prop up the economy. The new government might also need to act quickly to shore up confidence by announcing market friendly measures to stimulate growth. Some mega-projects might have to be taken off the shelf to put the economy back on track.

The Nation