The Federal Reserve Board looks almost certain to cut the US overnight interest rate on 11 December. Will that decision be kind or brutal? It depends what you care about.
The central bank could yet surprise the market, which is assigning a 94% probability to a quarter of a percentage point reduction to 4.25%. The US economy isn’t obviously in bad enough shape to need lower interest rates. But these days, the market, not the economy, calls the Fed’s tune. The central bank is afraid to surprise already fearful investors. If bankers become even more cautious about lending, the current liquidity squeeze could turn into a real credit crunch, which the Fed wants to avoid at almost any cost.
The Fed’s tight spot suits US investors just fine. While the long maturity of US mortgages means that troubled homebuyers aren’t much helped by lower rates, lower short-term financing costs are a boon to troubled lenders. So to them, a rate cut is an act of kindness.
But from the other side of the Atlantic, a cut looks pretty brutal, to use the word favoured by Jean-Claude Trichet, president of the Fed’s eurozone counterpart. Lower US interest rates encourage foreign holders to sell dollars. The greenback has been in near free-fall against the euro—down 3 cents in the last week and coming close to the psychologically important $1.50 (Rs58.95) level. A cheap dollar makes life hard for eurozone exporters.
Both of these judgements could eventually be reversed. A weak dollar pushes up import prices. That makes higher US inflation more likely. So in the US, the price of low rates now could be much higher rates later. The eurozone could also benefit eventually from the Fed’s apparent brutality. While strong currencies hurt trade in the short term, they often stimulate innovation and economic flexibility, just what the region needs. There are also the pride and profits that come with having the world’s premier reserve currency. The euro won’t gain that status right away, but it could if the Fed persistently treats the world in a too brutal fashion.