The Federal Reserve Open Market Committee (FOMC), which sets the overnight Federal funds rate in the United States, meets on Tuesday. The meeting has assumed importance in the wake of the emerging turmoil in the financial markets. Many want the Federal Reserve to take cognizance of the situation and signal its willingness to drop rates. Public pressure in a noisy democracy such as the United States is difficult to face down. But my assessment is that, on balance, the FOMC would conclude that it was too early to signal a rate cut.
In the last few years, most central bank officials have acknowledged a range of imbalances and conundrums. They include: proliferation of hedge funds, an explosion of debt in the financial system (despite tightening by central banks) and the carry-trade. Now that these imbalances have begun to unwind, it makes little sense for the central bank that was partially responsible for some of these excesses to develop to halt normalization. That would dent the credibility of the Federal Reserve and irreversibly damage the US dollar.
Dave Rosenberg of Merrill Lynch pointed out that, even in the Greenspan days, the Federal Reserve did not cut rates at the first hint of trouble. During the Asian crisis, the FOMC maintained a bias to hike interest rates until a big hedge fund collapsed and Russia defaulted on its debt. Similarly, in 2000, the FOMC kept up its tightening vigil until the Nasdaq composite index had dropped 40%. Hence, if Greenspan stepped in to put a floor under financial asset prices well into their process of decline, it is unrealistic to expect Bernanke to upstage his predecessor on that score. Bernanke favours an inflation targeting framework. He and his colleagues believe that inflation expectations among the public have not declined meaningfully, especially given declining productivity trends and potential growth in America.
Of course, some would say it’s different this time. The technology bubble and the Asian crisis were not accompanied by a build-up of debt of the magnitude seen during the last five years. Hence, there is a risk that the financial system might seize up, with economic consequences to follow. This argument should be dismissed with the contempt it deserves. If the culture of leverage and all the other vices that it spawned was due to ultra-low interest rates and a policy of laissez-faire that the Federal Reserve followed, it is vacuous to argue that they should be rewarded with an easier monetary policy. Bernanke has sent out clear signals that he intends to follow a different course.
Greenspan favoured self-regulation by market participants despite overwhelming evidence that they were singularly incapable of doing so. Left to its own devices, Wall Street looked after its short-term interests rather well —unmindful of systemic risk considerations. Agency problems and moral hazard were, and are, galore. This hands-off approach led Greenspan to be somewhat indifferent to signs of unhealthy practices in the home mortgage industry and excess build-up of mortgage debt. In contrast, Bernanke devoted half his testimony to the US Congress last month on the various measures the Federal Reserve and other regulatory agencies would now take to ensure the excesses of the recent housing boom are not repeated. So, given his quiet determination to distinguish himself from his predecessor, Bernanke is unlikely to take a leaf out of his book on throwing a lifeline to leveraged buyout funds, hedge funds and Wall Street banks.
Where does this leave the US dollar? Regardless of whether the Federal Reserve cuts rates or not in the future, the US dollar is likely to depreciate steadily against other international major currencies. There are many headwinds against the US currency. Readers must note that the US dollar would be weak against major currencies and not across the board.
Asian currencies—with the exception of the yen, the Taiwan dollar and the Singapore dollar—would underperform global currencies along with the US dollar. Most of them have strengthened in excess of levels justified by their economic and other fundamentals.
The Indian rupee is also likely to weaken over the next several months. The Indian stock market has been supported by overseas investors. They are more likely to cover their losses elsewhere by repatriating gains made in India.
Rupee weakness on top of dollar weakness might bring some temporary relief to the export sector, but it is more likely to be a signal of a realistic appraisal of India’s short-term economic prospects and hence might only be a partial compensation for adverse developments in other aspects of the economy such as foreign direct and portfolio investment.
(V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore.These are his personal views and do not represent those of his employer.)
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