The Hindu Business Line : US economy could spring upward surprise

Mr Ben Bernanke, the US Fed Chairman, is believed to be more model-driven in his decision-making than his predecessor, Mr Alan Greenspan. Going by last week’s (unanimous) vote to cut the benchmark interest rates 50 basis points, the message from his regression equations cannot have been happy.

The legendary Mr Greenspan puts the probability of a US recession at more than a third. Mr Bill Gross, the manager of the world’s largest bond fund, thinks the Fed has no choice but to cut another 100 bps in the next meetings. The futures markets too have factored in more rate cuts.

The fact is that even before the mortgage crisis erupted, the economy was perceptibly slowing. Fed cuts were coming, anyway, sooner or later. Willy nilly, they had to be brought forward following the breakdown of credit markets.

Key questions

The key questions are how the American economy is going to perform and how far the Fed will (or must) go with its rate cuts.

There are some crucial signs that there is a thaw in progress. First, if, as seems likely, the mortgage and CDO portfolios of investment banks are not in such bad shape as feared, credit markets could see a quick turnaround, the evidence of which was already there last week in the easing of LIBOR spreads on Fed Funds.

Second, US stock markets rose for days in a row, suggesting ‘big’ and ‘smart’ money sees value even in these dog days. Also, the results of some investment banks, including the big daddy of them all, Goldman Sachs, were better than expected.

Falling house prices are destructive of wealth, but, if confined to the sub-prime sector, may not have widespread adverse effects on the economy. A quick bounce back would, therefore, not surprise and the Fed may not have to go as deep and prolonged in its cuts.

Yields shoot up

Reflecting, perhaps, the renewed confidence of market players, yields on 10 year Treasuries actually shot up no less than about 30 bps immediately after the rate cut. The explanation that it was inflation fear in a rate-softening environment does not convince as the CPI data has been far from threatening in the last several months.

Did Mr Bernanke and his colleagues put their heart and soul into the rate cut or were they stampeded into it? One must wait for their post-retirement memoirs for an answer, but on this occasion it seems they thought the risk calculus clearly favoured slashing rates.

They may yet be rewarded with a rapid turnaround of the economy making a lax monetary policy unnecessary.

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