The Hindu Business Line : Fed cut in sight

The recent spate of data has been almost entirely gloomy. The housing boom, spurred in the last five years by extraordinarily low interest and mortgage rates, was seen as a bubble waiting to burst. The Federal Reserve and, in particular, its then Chairman, Alan Greenspan, were blamed for making money artificially cheap - at one point, the Fed Funds rate held at just 1 per cent for as long as two years. But circumstances were different.

Greenspan (and, it has to be said, the present Fed Chairman, Ben Bernanke, who was at that time Greenspan's colleague on the Fed's interest rate-setting body, the Federal Open Market Committee - FOMC) feared deflation would take root in the US economy as it indeed had in Japan.

And Japan's deflation was preceded by a stock market crash, when, instead of cutting interest rates the Bank of Japan raised them. The resemblance was almost eerie and Greenspan was naturally loath to commit the same mistake.

Low interest rates create excess air in an economy, which must find an escape route. In this case, house prices acted as the (if they can be so-called) safety valve and escalated. Even so, the boom was confined to select parts of the country - notably the east and west coasts.

Soon, sure enough, the Fed had to raise interest rates. The process of `normalising' was fast and furious. In 17 successive meetings, the Fed moved from 1 per cent to 5.25 per cent.

The idea was to reach a `neutral' level, which would be neither stimulative nor restrictive. Alas, if things were that simple. Greenspan would have probably liked to pause at 3-4 per cent levels. But, to his bad luck, inflation started to tick up just when he would have preferred to stop and watch the effects of the hikes.

Of course, the hawks in the FOMC would have hardly allowed a breather.

It is not that sectors other than housing inspire much confidence. Manufacturing is weak as are indices such as the Chicago PMI and ISM, which dived to recession-like levels. Job growth is decent, but nowhere near the gung-ho years of President Clinton.

The bond market is in no doubt that the economy is going `soft'. Yields on 10-year treasuries have dropped below 4.5 per cent, deepening the inversion of the yield curve.

But Mr Bernanke has given no hint yet of a cut. In fact, in his latest speech, he worried more about inflation risk.

Bad data will force his hand. About the only bright spots, relatively speaking, are jobs and the wages of those lucky enough to have jobs.

The market is unambiguous that the next Fed move will be on the downside and it is likely to be right.

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