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The
US Federal Reserve Board's decision to cut interest rates by
half a percentage point on January 3rd has taken most observers
by surprise. This is even though several analysts had suggested that
the Fed may have to take some such measure in order to prevent a further
recessionary slide, as the US economy finally slows down after a seemingly
endless decade-long boom. There are several reasons for the surprise.
First, the decision came close
to four weeks before the next meeting of the federal open market committee,
which meets periodically to review monetary policy and decide on interest
rates. The last time a similar decision was taken in an emergency
meeting was when the financial crises in East Asia, Latin America
and Russia threatened a global financial collapse.
Second, the reduction comes
in the wake of a six increases in short term interest rates from close
to 5 per cent in June 1999 to 6.5 per cent in May 2000 (Chart 1),
and therefore marks a change in direction. Further, the one-shot 50
basis points reduction was uncharacteristic of the Fed, which has,
in recent times, preferred gradual changes of a quarter of a percentage
point at a time in the interest rate. The move signaled not just a
change in direction, but a sharp reaction as well.
Chart 1 >>
Finally, the cut has been
justified by the Fed in terms that indicate that it saw the action
as necessary to forestall a slump. To quote the Fed's announcement:
“These actions were taken in light of further weakening of sales
and production, and in the context of lower consumer confidence, tight
conditions in some segments of financial markets, and high energy
prices sapping household and business purchasing power.” In a
feeble effort to boost confidence, however, the Fed went on to assert
that “to date there is little evidence to suggest that longer-term
advances in technology and associated gains in productivity are abating”,
even though the information currently available suggests that “the
risks are weighted mainly toward conditions that may generate economic
weakness in the foreseeable future. “
No one can deny that the US
economy, which entered a record-breaking tenth year of continuous
growth in February last year, has been running out of steam since
the third quarter of 2000. Having grown at an average rate of well
above 5 per cent in the year stretching between the third quarter
of 1999 and the second quarter of 2000, US aggregate output growth
slowed sharply to 2.2 per cent in the third quarter of 2000, and is
expected to be even lower in the final quarter of last year (Chart
2), figures for which would be available by the end of January.
Chart 2 >>
However, while these annualized
quarterly growth rates are among the lowest recorded in recent times,
they would have normally been seen as a necessary correction to the
marked and prolonged boom in the US economy, which has brought unemployment
rates down from 7.5 per cent at the beginning of the 1990s to 4 per
cent last year (Chart 6). In fact,
the Fed's actions that continuously raised interest rates over
the year ending May 2000, indicated that it wanted to apply the breaks
on an economy that was growing too fast, even if without spurring
inflation.
The puzzle therefore relates
to the reasons why, despite this long history of more than satisfactory
growth, Alan Greenspan and his colleagues found the need to intervene
as strongly as they did at what seems to be the beginning of a downturn
whose lifespan is still uncertain. Judged by its own reasoning, the
proximate cause for the Fed's knee-jerk reaction seems to be
its perception that underlying the downturn is a waning of consumer
confidence and the prospect that rising energy prices may sap consumer
purchasing power.
The focus on consumption stems
from the fact that the US boom has indeed been consumption driven.
During the years 1997-99, accelerating growth was accompanied by a
sharp increase in personal consumption expenditures, led by consumer
expenditures on durable goods (Chart 3). These were the years when
the deficit in the United States government's turned to a surplus,
and American exports lost out in world markets while imports invaded
domestic markets, taking the current account deficit on the US balance
of payments to close to a record annual $400 billion.
Chart 3 >>
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