Fed cuts may be too late to avert slump

Key US interest rates have now been trimmed by 1.25 percentage points in eight days, writes Paul Tansey

The Federal Reserve Board - the US central bank - yesterday mounted a last-gasp attempt to snatch the US economy from the jaws of recession by again cutting interest rates.

The key Federal Funds rate was reduced by half a percentage point to 3 per cent, the second time US interest rates have been cut in the last eight days.

The Fed has been clipping US interest rates since last September, as the enormity of the subprime lending crisis became increasingly apparent. Since then, US interest rates have been reduced on five occasions, with the Federal Funds rate falling from 5.25 per cent to 3 per cent in the process.

However, the US authorities have really only awoken to the reality of the recessionary threat in the last fortnight. Their efforts to avert recession have embraced both fiscal expansion and a distinct easing of monetary policy. On the fiscal front, president George Bush introduced a $146 billion expansionary package on January 18th, focusing on tax breaks that would put more cash into the hands of households and corporations. This fiscal package represents an injection of some 1 per cent of GDP into the US economy and is currently making its way through Congress.

Unimpressed by the Bush package, global markets promptly panicked. In consequence, at an unscheduled meeting of the Fed on January 22nd, interest rates were cut by three-quarters of a percentage point.

Yesterday's further half-point reduction means that key US interest rates have now been trimmed by 1.25 percentage points in eight days. This represents a significant easing of US monetary policy and will reduce the cost of credit on variable rate home loans, credit cards and business borrowings.

But while the cuts in US interest rates may not be too little - inflation has not gone away - they may be too late to avert a recession. Economic growth slowed to a crawl in the final quarter of 2007, according to figures published yesterday by the US Department of Commerce. Real US Gross Domestic Product (GDP) increased at an annual rate of just 0.6 per cent in the fourth quarter of 2007, a precipitous fall from the 4.9 per cent annual GDP growth rate reported for the third quarter.

The US slowdown in the final quarter was much more pronounced than anticipated. Consensus forecasts had projected an annual growth rate of 1.2 per cent in the final three months of 2007.

A recession in the US would inflict severe damage on the Irish economy. A recent International Monetary Fund working paper has found that shocks to US economic growth have a larger impact on the pace of Irish economic activity than shocks of a similar magnitude in the euro area or Britain. The European Central Bank has held firm on the interest rate front since last summer. However, the scale and persistence of the cuts in the cost of US money is increasing the pressure on the ECB to adjust interest rates downwards.

With US interest rates falling and euro-zone interest rates apparently fixed, funds will continue to flow from the dollar to the euro. This would cause the euro to strengthen further against the dollar, making its increasingly difficult to sell euro-denominated exports on slowing international markets, especially when competing against super-competitive US dollar-denominated exports.