Ben Bernanke's federal reserve discount rate cut decision

Monetary Policy & Interest Rates

Financial activities in a country are governed by macroeconomic policies of a government implemented with the help of a central bank in most of the countries. Commercial banking system also makes an integral component of the financial system of a country along with savings banks, insurance companies, investment banks etc. Informal system of money transfer and financial dealings also make a part of the financial system. Macroeconomic financial policies also sometimes called monetary policies deal with these aspects of an economy.

Monetary policies regulate the interest rates and the quantity of money. So, the monetary policies help in establishing a relationship between money, financial markets and product markets. Central banks of countries like the Fed in United States try to maintain conditions of full employment and stable prices by regulating money supply and levels of interest rates. "Three groups help determine the money supply: the central bank, private banks and the general public. The central bank sets the monetary base while private banks and the general public interact to determine the money multiplier which is the ratio of the money supply to the monetary base" (Abel & Bernanke, 1998).

The fed funds rate is what banks pay to borrow money overnight. Interest rates affect the lending of money by the banks. As interests rates increase banks give more loans and when interest rates fall banks control the amount money to be lent and try to increase their exchange reserves. If the purpose of the government or its central bank is to decrease the aggregate demand over a period of time then the nominal interest rates in relation to the inflation rates are increased. However if the purpose is to increase aggregate demand then reduction in nominal interest rates in relation to the expected rate of inflation is done. Lower real interest rates induce investments while higher real interest rates cause the decline in planned investments by the businesses or individuals. So, the reduction in real interest rates cause increase in demand of investment goods resulting in the increase in the aggregate purchases.

Bernanke's Move

In an unexpected move Fed Chairman Ben Bernanke, who has written extensively as an economics professor on the Great Depression that followed the 1929 stock market crash, announced a dramatic cut in the Federal Reserve's discount rate by half percent to 5.75%. The surprising factor was that Bernanke has shown more caution as compared to Greenspan and has been a critic of investors or real estate speculators who made bad decisions but his decision to cut is most likely to favor the same people. However, the reports of unemployment and nation loosing the jobs, portraying the gloomy picture, might have pushed the Fed to make such a move. Also the conditions in the sub-prime mortgage loans and a continued downturn in housing were getting worse causing a panic in credit markets. These conditions particularly the news of unemployment made certain that there would be a rate cut but the debate then shifted on how much to cut the rate as compared to whether to cut the rates or not. There were many speculations about the impending recession. Stock market had its own estimation that the chances of an impending recession is one-in-three or somewhat higher which was similar to the estimation by Greenspan who placed it at more than the one-in-three earlier this year.

After the terrorist attacks on the World Trade Center, the central bank has been struggling to get financial markets back into operation but did not make any significant changes in the Fed rates. In 2001, the panic in financial markets resulted because of the air that went out of overblown dot-com stocks while currently the panic is in credit markets due to dubious mortgages on inflated housing prices. Federal funds rate had been untouched since a long series of rate hikes and finally a move was made to cut the rates. A quarter point cut was expected but many have called half point cut a bolder move. The move gave banks an incentive increase short-term lending. The rate cut also means lowering borrowing costs for businesses and consumers. Consumers can borrow loans at lower costs for mortgages and automobiles. However, Fed at the same time has cautioned that investors and consumers should not hope for further changes later this year.

Many have called Bernanke strategy a balanced move to the on-going financial markets crisis as compared to the quick-fix approach of the Greenspan Fed. The Fed seems to have objectives on economic growth and price stability and so it availed the discount window option, by targeting liquidity relief at those institutions in reality needing it.

Financial Market Response

The discount rate cut was seen favorably by the investors with Dow Jones industrial average shooting up. Financial markets have not been pinning any hopes on Bernanke much like his predecessor, Alan Greenspan as Greenspan did not respond to initial signs of market distress. Bernanke's move has made investors happy but at the same time Wall Street expects the central bank to keep cutting rates.

Possible Negative Repercussions

The biggest threat of such a move is inflation. Inflation is usually the biggest threat in response to an attempt to stimulate the economy with cheaper money. Fed has been reluctant to change interest rates because the predominant risk to the economy was that inflation would not slow as expected but the move was made when the dowunturn in economy became a greater concern than inflation. Had they cut rates too cautiously, there was a risk of recession but stirring up inflation was the main concern with cutting rates too much. The most significant likely is the long-term negative effect of the sinking dollar, as U.S. dollar has been falling against foreign currencies. When U.S. dollar falls against foreign currencies then it takes more dollars to buy foreign imports, creating an inflationary impact. Critics also argue that the change would not make much of a difference in an average American's life as the impact on major expenses like gasoline and food would be next to nothing.

Future Ahead

In the face of global credit crisis, it is expected that Fed has to make further changes such as cut in the more important federal funds rate to maintain stability. The pattern of growth is likely to change showing a slow down. "Mark Zandi, chief economist at Moody's Economy.com, has trimmed his forecast to show economic growth of about 2.5% in the current quarter, down sharply from 4% in the April-June quarter. He said the fourth quarter is likely to be even weaker at around 1.5%" ('Fed surprises markets with half-point rate cut', 2007). The policies of rate-cutting could be more disturbing because of warnings about inflation at a time of slowing growth. The turmoil in the credit markets is not likely to be reduced overnight. The changes might be observed after a while however not without some of the negative repercussion. A lot also depends on the future moves by the Fed.