Fed keeps options open with moderate cut

Federal Reserve remains worried about the threat of deflation, writes Cliff Taylor, Economics Editor.

The only question before yesterday's announcement about US interest rates was whether the Federal Reserve Board was worried - or really worried - about the risk of deflation.

In the event, the Fed trod a middle line, cutting its base interest rate by 0.25 of a percentage point rather than half a point, but making it clear in its accompanying commentary that there might be more to come.

Whether the second half of the loaf is delivered later this year depends on the performance of the US economy.

There have been some tentative signs of a rebound, particularly among consumers and in the housing market. But industry remains indebted and investment low.

Concerns remain about the enormous current account deficit on the balance of payments, evidence of the extent to which the US has imported more than it has sold abroad in recent years.

So the Fed will adopt a wait-and-see approach for the next couple of months to judge whether the low interest rate remedy is working.

Crucially, its statement yesterday made clear that it still feels deflation poses a greater risk than inflation.

Moreover, it said that the risk of deflation was likely to "predominate for the foreseeable future" - a clear signal that interest rates would stay low and could fall further.

The Fed has cut interest rates 13 times since late 2001 in an attempt to boost the economy.

Studies published by the Fed's research department give an insight into its reasoning. In particular, a study of the Japanese economy - stuck in a deflationary slump since the late 1990s - shows that the Japanese central bank should have cut interest rates more aggressively in the early 1990s, which might have avoided many of the subsequent problems.

The central point of this analysis is that it is worth doing everything possible to avoid slipping into a deflationary slump because, once you're in one, it is very difficult to get out.

This means that the Fed is willing to take a measured risk of an inflationary pick-up as recovery sets in, to try - in the words of its chairman Mr Alan Greenspan - to create a "firebreak" against deflation.

So, we may well see US rates falling to 0.75 per cent, or even lower, if the economy does not start to recover by early autumn.

What does the US cut mean for Europe and Ireland?

By widening the gap between US and euro-zone base rates - now a full percentage point - it probably makes another euro zone cut a little more likely.

One may well be on the way in the months ahead in any case, given the poor state of the main euro-zone economies. The European Central Bank, however, does not seem to have signed up fully to the "avoid deflation at all costs" policy favoured by the Fed.

Given the poor outlook for the euro zone, the main hope for an early pick-up in the Irish economy would come from a US-led international recovery. Despite the Fed's cut, it remains unclear whether this is in prospect.

The US economy is subject to considerable stimulus from the combination of falling interest rates, the lower dollar and tax cuts.

However, the outlook is, at best, for a gradual recovery in growth. The long-awaited international recovery will remain "just around the corner" for some time.

The Fed will hope to avoid the emergency medicine of cutting rates below 1 per cent, although it will do so if it needs to.

However, with rates already at historic lows,it is debatable how much more stimulus further cuts in borrowing costs can bring.

For the next few months, it is a case of waiting to see whether the worst is over for the world economy.