On Tuesday, the Fed chose to slash interest rates from 1% to a range between 0.25% and 0%, their lowest level in the 232 years of its existence in what now must be the last in a series of rate cuts that have taken place since September of last year when the rate stood at 5.25%. The move follows a spate of recent unprecedented cuts across the majority of the World's western economies, including the UK. For more analysis, see the recent article on the base rate cut on the top right of the page
Why do this?
Ben Bernanke, Chairman of the Federal Reserve, issued a bleak statement following the decision, declaring that "the outlook for economic activity has weakened further" since the last interest rate decision had been made. Cutting rates is the primary means by which the Fed can attempt to stimulate the economy, reducing the cost of borrowing money for banks which should in theory encourage them to borrow more and themselves to lend more to consumers and businesses. It said it expected to keep rates at ultra-low levels "for some time" and vowed to use "all available tools to promote the resumption of sustainable growth and to preserve price stability".
The other factor involved is inflation. Whereas during the first half of the year the Fed as well as central banks across Europe and the West were limited in their ability to cut rates by the threat of rising inflation, inflationary pressures appear to have subsided over the past 2-3 months as recession sets in and the cost of goods, particularly fuel, have fallen considerably. The drop in oil prices has been especially dramatic as consumption levels in the West and emerging economies alike have fallen on the back of reduced output. For recent explanation see this article on the oil price drop
Deflation - The dark cloud on the horizon
The new threat, according to most economists, is deflation, whereby the price of goods, instead of increasing by a set amount each year, actually decline. This is a fairly common occurrence during periods of recession (and, more worryingly, economic depressions).
Deflation generally occurs as the supply of money in the economy cannot keep pace with the growth of the population and/or economic growth so that the amount of money available per person in the economy decreases as has been the case with the credit crunch of the last 15 months. The problems caused by deflation are numerous and generally thought to be more severe than the problems associated with high inflation as the net result is usually an increase in the length and severity of an economic downturn. Japan has suffered from deflation for much of the last decade following the recession at the end of the 1990s - the Japanese Central Bank kept interest rates at 0% for a period of four years and they are still hovering around 1%. Whereas a low level of inflation is good for keeping the economy ticking over, encouraging people to spend and invest their money in the expectancy that goods will rise in value, when prices are stagnant or even expected to fall, spending is put off as the quantity of good that, say £100, can buy is anticipated to be greater a few months down the line than it is at present. The purchasing power of each unit of currency is thus increased but ironically people feel less inclined to part with their as they feel that their wealth is more secure in cash form than in investing in assets which are prone to devaluation.
Another knock-on effect is unemployment as salaries paid by companies to their employees remain the same whilst the amount firms are able to charge for their services are forced down. The end result is employers being forced to reduce wage bills either by cutting existing wage levels, or, more likely, by cutting staff. For more information on unemployment in the modern age see this article in our archive.
Quantitative easing, aka printing money
There are ways of combating deflation, one of which is by cutting interest rates as the Fed has already done. Another is called 'quantitative easing': injecting more capital into the system using the country's reserves. Put simply, this means making more cash available to consumers and corporates. The Fed is able to do this by taking less liquid financial assets out of the system and holding them on the central bank's balance sheet, and replacing them with cash. The effect of this should be to bring down the value of money and encouraging spending and investing rather than saving. There are problems associated with this, as the current predicament suffered by Zimbabwe will attest, not least the potential for the currency in question, in this case the Dollar, to loose a substantial part of its value. As the US Dollar remains the World's most utilised foreign currency, however, its value will still be largely maintained by the strong worldwide demand. Another long-term repercussion is that this will merely be creating another boom which will ultimately be unsustainable.
The irony is that it is suspected that the current credit crisis and ensuing economic downturn was largely fuelled by the attempts by the Fed to drag the economy out of the last period of [threatened] deflation. Following the Dot-Com Crash, interest rates were cut significantly in the US and borrowing and risk taking amongst consumers and corporates were encouraged by the economy in a bid to avert a deflationary movement following crash. The effect of this was to create an economic boom around the mid part of the decades which pushed up prices of assets, particularly houses, and credit levels to a state that was unsustainable.
Whether these efforts will be enough to get the economy moving again, however, remains to be seen. So far markets across the globe have responded well to the rate cut with the Dow Jones rising by over 4%. The very fact that the Federal Reserve has taken such a drastic step in its efforts to boost the economy, however, suggests that the prognosis for the US economy is worst than it had originally feared. The most worrying aspect is that with interest rates practically at rock bottom (they cannot go below 0%), the Fed has little left in its armoury to combat both deflation and an economic downturn. Let's hope that Obama's recent economic stimulus plan will go some way to reversing the trend. See our recent analysis on Obama's plan.