When the US Fed cut short-term interest rates by 0.5% on Tuesday, markets around the world surged on the hopes of an improved economic outlook for the US economy. Both NYSE and S&P 500 went up by 3%, with similar moves by most other indices around the world.

But the “irrational exuberance" that I am referring to is not of the market reaction to the Fed rate cuts, but the rationale and outlook as perceived by the US Fed in support of the rate cut. Contrary to providing a stimulus under a condition of moderating inflation as the Fed claims, this rate cut is going to push the US economy into an inflationary recession with the dollar continuing to lose value against other major currencies and commodities.

To understand the rationale for the above, it is important to understand the current predicament the US economy is in. The problems facing the US economy and the effect of the rate cut on the same are as follows:

A collapsing dollar

The dollar has lost anywhere between 30% and 90% against most leading currencies (Australian dollar, Canadian dollar, euro, pound, New Zealand dollar, South African rand, Swedish krona, Swiss franc) in the last five years. A rate cut at this stage increases the attractiveness for holding other currencies and hence the trend of the US dollar losing value against other currencies would only increase.

Negative savings rate

The US consumer has a negative savings rate with increasing extractions from their latest credit card, that is home equity, to finance their consumption. It’s hard to make an already negative savings rate worse, but that is exactly what a rate cut would do at this stage. The rather few Americans who actually save at this stage would see their purchasing power erode on the savings and, hence, would be forced into spending rather than saving.

High inflation

With money supply in the US economy growing at an estimated 14% and the “official" GDP growth rates at 2-3%, how could inflation be at 3% as the Fed would like us to believe (readers would do well to remember that the definition of inflation is “supply of excess money and credit relative to the goods and services produced"). Even if you want to measure in terms of consumer prices, how could we have a low inflation with both crude and gold prices (monthly averaged) quoting at their all-time high prices? Only another central banker would be naïve enough to believe such absurd statistical sleight of hand. With the rate cut, the situation gets worse with increasing prices of commodities (both oil and gold moved up sharply subsequent to the cut and we can pretty much bet that the trend will continue in the months ahead) thereby worsening the situation of negative real interest rates.

Housing bubble

There is no conceivable way in which the “bubble" prices can be maintained; housing prices have to collapse before affordability can return to the US consumer. While the objective behind the rate cut was ostensibly to stabilize prices, all this will do is to hasten the collapse. This is because at the same time the Fed was cutting rates in the short-term, long-term yields were actually rising (due to the problems of holding the less attractive dollar and higher inflation mentioned above). So, a cut in the short-term interest rates is actually going to cause an increase in the long-term rates that the consumers pay on their housing loans.


US consumers have been on a spending binge for the last two decades where they have consumed far more than what they produce resulting in annual trade deficits to the tune of $800 billion (Rs31.92 trillion). This rate cut reinforces the trend of over-consumption by making short-term credit more easily available (for consumers) to indulge in such capital-destructive actions.

In some sense, the collapse of the housing bubble was the last chance for the Fed to have demonstrated a semblance of monetary integrity by allowing speculative credit to be destroyed. While it would have resulted in an immediate recession, such an action would have actually improved the long-term prospects by forcing US consumers to under-consume (that is, live within their means), save, and invest in productive facilities. Instead, they have chosen to continue the game of loose credit by protecting speculative behaviour. It is indeed amusing that the Fed solution to all of the above mentioned problems that have been fundamentally been caused by an accommodative monetary policy is a still greater accommodative policy. All this will do is postpone the recession by a few months, while causing the fundamentals to deteriorate further.

The current action by Fed chief Ben Bernanke reminds me of Captain Edward Smith of the Titanic (the ship’s sinking is the equivalent of the housing bubble collapse for the US economy). The current rate cut is about as sensible as Captain Smith’s action of reassuring the passengers that all was well and that they should continue to party.

In an earlier article in Mint (‘US housing: arms without legs’) that appeared on 5 September, I had explained why a US recession is imminent in the months ahead. Given the rather irresponsible rate cut witnessed, I would like to qualify the same now: it is going to be an inflationary recession wherein the prices of all the things the US imports (commodities, consumer goods) would go up while the prices of all the assets the US consumer owns (US equities, bonds and real estate) would go down.

The author is director, Benchmark Advisory Services. Write to us at ­feedback@livemint.com