A Delicate Balancing Act

Prospects for US interest rates remain firmly in the spotlight. An unscheduled and drastic cut in US rates in January was swiftly followed by an additional and substantial reduction at the Federal Reserve’s scheduled January meeting. In March, another 0.75% cut was announced as markets reacted badly to the takeover of Bear Stearns by JP Morgan Chase following a US$30 billion Federal Reserve (Fed) aid package. US interest rates are now just 2.25%.

Nevertheless, investors remain nervous and the Fed has been criticised for what some economists view as a short-term approach to the deeper-seated problem. The economic outlook continues to deteriorate following the collapse of the domestic housing market, the global credit crunch, and soaring fuel prices.

US interest rates have now undergone six cuts since September 2007 – so where do we go from here? The Fed has cut its forecast for economic growth in the US and appears to anticipate a greater-than-expected rise in unemployment over the course of 2008. Meanwhile, inflation is forecast to reach as high as 2.4% in 2008, driven by surging prices. The current scenario has raised the unwelcome spectre of stagflation, in which prices continue to rise while growth stagnates.

Despite the risks to inflation, the deteriorating environment had boosted expectations of interest-rate cuts in 2008, and Fed chairman Ben Bernanke has favoured monetary easing to stave off a recession in the US and ease the effects of the credit crunch. Lower interest rates in the US will have a direct influence on the global economy: the US economy is still the largest in the world and an economic slowdown in the US would have a negative effect on economic growth in many countries in Europe and Asia, where exports to the US can make up a significant proportion of revenue.

Any recovery in US demand would be well received, but lower interest rates do undermine the already weak US dollar, providing additional impetus for the booming oil price, which could stoke inflationary pressures. Where the Fed now goes from here remains to be seen, but policymakers are having to perform a delicate balancing act in trying to ensure the economy does not stall, at the same time as keeping inflation in check.

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