A tough choice

A tough choice

The equity markets have welcomed the deep 50 basis point reduction in the US federal funds rate on Tuesday, perhaps taking succor from the fact that similar cuts in the earlier years of this decade had revived sagging share prices globally.

But these are different times. The world economy was battling the threat of deflation when Alan Greenspan slashed benchmark US interest rates and created the infamous housing bubble in the world’s largest economy. It was also around this time that an academic economist named Ben Bernanke said in a speech that a central bank is justified in dropping money from a helicopter to keep deflation at bay.

We now live in times of heightened inflationary expectations. Food and fuel prices are soaring. The synchronized economic boom of the past few years has generated wage pressures in many countries. China is now exporting its inflation to the rest of the world. The dramatic loosening of US monetary policy at such a time is a huge gamble, though it is one that Bernanke perhaps had to take given the tremors in the housing and credit markets in the US and the rest of the world.

The US Federal Reserve chairman has argued in his academic papers that a central bank should not cut interest rates to bail out financial investors, unless there is proof that a seizure in the markets will affect the real economy. The cut in the federal funds rate on 18 September thus suggests it is possible that Bernanke sees signs of trouble far beyond the current weakness in the US housing market and the lending freeze in the credit markets.

The erosion in the value of the world’s most important currency is no minor matter, and something that markets will have to face up to when their ardour cools down. The Fed, in its policy statement, has given a hat tip to these concerns: “some inflation risks remain," it says weakly, which is miles away from what it was saying as recently as two months ago—that inflation is the big threat to the global economy.

Other central banks, including the Reserve Bank of India (RBI), will now have to adjust their monetary policies in response to the Fed’s lifeline to the financial markets. The decline in the dollar will mean stronger currencies elsewhere, especially the euro, yen and various Asian currencies (including the rupee). That could change the dynamics of trade and investment. These central banks will also be under pressure to cut interest rates to protect their currencies from further appreciation, despite higher inflation. Indian industry is currently, vocally lobbying for this, and RBI will be under tremendous pressure to fall in line. By cutting interest rates, Bernanke has fanned inflationary fires.

What is hard to gauge at this juncture is whether lower interest rates and a liquidity injection will hold up real estate prices in America and Europe and whether the credit markets will come out of their stupor to start lending again. Policy focus around the world shifted from inflation to financial instability in August. But looking the other way doesn’t mean the inflation genie has crawled back into the bottle.

Bernanke had to make a difficult choice between fighting inflation and calming the markets. He has chosen the latter. In case his gamble fails, the world could be headed for a noxious combination of lower growth and higher inflation.

Should Bernanke have aggressively cut the US interest rates? Write to us at views@livemint.com