Can Fed support another rate cut?

Global equity markets, especially emerging markets, have surged to lifetime highs after last month's US Fed rate cut. But many of these markets are close to bubble territory while investors are ignoring the growing risks.

Ben Bernanke did what any sensible central banker would do when faced with demand slowdown in the economy. Size of a rate cut is always debatable, but it is well accepted that such measures should surprise if monetary policy is to be effective. A full-blown crisis in the financial markets and tight liquidity would have worsened the already weak outlook for the US economy.

Nobody likes a recession, not even central bankers, especially ahead of a presidential election. As a columnist said in the Financial Times yesterday, "in democracies bad stuff is outlawed" if politicians want to be re-elected.

But a large interest rate cut is like giving first aid to an accident victim, which in this case is the US economy. First aid is delivered without knowing or checking the full extent of injuries and it is often difficult to predict whether the patient's condition will improve. All that is known is that the victim is injured and will take some time to recover.

If the economy is weak, with increasing risks of it turning even weaker, and emergency support has been given in the form of an interest rate cut, why are markets so bullish? Strange as it may sound, but it is because conditions may get even worse and more rate cuts may follow!

Rate cuts bring the omnipotent force called liquidity into the markets and everyone will be happy and more prosperous. Declining corporate performance in a weak economy and soaring stock valuations be damned.

On the other hand, The Federal Reserve's decision last month to cut interest rates by a larger-than-expected half-percent point sent the already-weakening dollar to an all-time record low against a basket of six major currencies. In the third quarter, the euro appreciated more than 5% against the dollar, most of the gains coming in September alone.

Weakness in the dollar means prices of imported goods, particularly oil, will go up, raising the risk of inflation. American consumers will be paying more soon, with the looming threat of paying even more later on.

"The inflation risk from higher import prices will be the dominant initial effect," said Howard Chernick, an economics professor at Hunter College in New York. "The most immediate effect is imports denominated in dollars -- mainly oil. We already saw a spike in oil prices. So a bit down the line, that's 10 to 15 cents more per gallon of gas at the pump."
A weaker dollar can help narrow the U.S. trade deficit by making America's exports more affordable abroad.

Yet it could also make funding those imbalances more difficult. The U.S. has to attract billions of dollars a day from foreign investors, and a weakening currency makes dollar-based assets less attractive because of the consequences it can have on their long-term value.

That fear of inflation came into focus on Friday when a top Fed official suggested policy-makers have already cuts rates enough, a view reinforced by fresh data showing U.S. employment grew at a steady clip in September.

Inflation, as the late economist Milton Friedman once wrote, is taxation without legislation. Rising prices rob consumers of purchasing power, destroying the value of their savings over time.

Inflation turns savers into losers, at a time when America desperately needs more savers to fund its imbalances -- particularly if foreign investment starts to taper off. But fears of rising prices will keep consumers cashing their paychecks and heading to the mall, rather than depositing the funds in accounts whose returns might lag the inflation rate.

Having said this, What if Ben Bernanke decides that financial markets have partied enough, and decides to focus more on his pet peeve — inflation? Then he may hike interest rates or keep them steady and the markets will be in for a huge disappointment. We all know what happens when markets are disappointed, especially when the indices are at lifetime highs — investors panic.

Let us wait to see what will Fed vote for a rate cut to save recession ahead of presidential election or to save inflation in the next meeting?

- Compiled from various sources