In a last ditch effort to forestall the US economy's descent into recession, the Federal Reserve Board - the central bank of the United States - cut official US interest rates by three-quarters of a percentage point yesterday. The key federal funds rate was reduced from 4.25 per cent to 3.5 per cent. The Fed's move to ease US monetary policy can be seen as complementing the $150 billion expansionary fiscal package announced by US president George Bush on Friday.
The jury remains out on whether the combined effects of relaxing monetary policy and expanding demand through tax cuts are sufficient to snatch the US economy from the jaws of recession. However, the markets were convinced that Mr Bush's fiscal package, standing alone, was incapable of rescuing the US economy from imminent recession. Its announcement last Friday triggered a wave of panic selling on global stock markets that carried through to yesterday morning. The Bush package was seen as too little too late.
The Fed's interest rate cuts received a warmer reception from a surprised market. Wall Street had been closed on Monday for a bank holiday and had thus avoided the market meltdown. Share prices were expected to open much lower in New York yesterday as a result. But the Fed's pre-emptive strike on interest rates contained initial losses on Wall Street while allowing European markets to recoup much lost ground. The Dublin market closed 3.75 per cent higher yesterday with London registering a 2.9 per cent gain.
It has not been a happy new year on international stock markets. Share prices have been driven downwards by the growing fear of a US recession. This stems from many factors. First, the sub-prime mortgage lending crisis has caused US banks to sustain heavy losses while at the same time inducing a major contraction in housing output. The global losses now recognised by international banks on foot of sub-prime lending exceed $100 billion. Second, the fall in US house prices has reduced the wealth possessed by US households. As a result, households are curbing their spending and this has been reflected in weakening consumer demand.
Third, the credit crunch, induced by the sub-prime crisis has constrained the amount of credit available to both businesses and households. This had led to a further dilution of US domestic demand growth. More recently, weakening aggregate demand has been reflected in a softening labour market, with unemployment rising to 5 per cent.
Many of these recessionary risks have been in evidence for some months. But investors chose to ignore them until very late in the day. Now, the reality is sinking in. A US recession is bad for the global economy; world economic growth cannot be "decoupled" from US economic performance. The risks of a US recession are real and increasing. These growing risks have been priced into global share prices at last.