It may not be the best news for the macroeconomy, but financial panic and impending recession at least make things more interesting. Here's the article today from the Washington Post on the drop in global stock markets, the Fed's emergency rate cut, and the possibility that we'll head into recession.
The link between stock markets, the Fed, and recessions is something we'll address as we go through class. For now, you can think of it this way. If the economy is going along normally, then the financial markets are taking your savings and pushing them out to different firms who invest these funds (either by lending the firms money or by investing in the firms stocks). The firms who get your savings use them to hire more people, buy more machines, or buy their CEO a new gold bathtub.
When financial markets get panicked, though, they are wary of giving your savings to firms, because they think the money will disappear. So they essentially hide your savings under the mattress as cash, and firms don't have access to new funds to hire new people or buy new machines. So economic activity slows down.
The Fed is trying to induce the financial markets to keep lending. How? We'll get to that in the next couple of days.
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The article "Fed Cuts Interest Rate to Stem Panic" conveys that on January 22nd, 2008 the Federal Reserve took drastic steps in an effort to prevent widespread stock market losses across the globe: it cut interest rates by three-quarters of a percent. This compares to the half point cut that was made after the September 11th terrorist attacks. By issuing the percentage cut, which was the largest in 24 years, the Federal Reserve was able to accomplish its objective. The Dow Jones industrial average decreased by 1.1 percent, which was far less dramatic than the 7 percent decrease Asian and European markets experienced earlier in the week. In addition to mitigating a potential sharp decline in the Dow Jones index, the European and Asian markets moderated after the rate cut was announced. Investors in futures markets also predict that the Federal Reserve will cut rates once again at its upcoming regularly scheduled meeting.
One effect of the rate cut is lower cost for both consumers, who borrow money through credit cards and home equity loans, and for businesses which take out loans to expand. The rate cut should also lead to lower rates on adjustable-rate mortgages while long term, fixed rate home loans are likely to remain unaffected. Lower rates also cause weakness in the dollar, which should help U.S. exporters, as well as possibly help banks become more profitable and rebuild their capital, thereby gaining more solid footing.
While foreign markets moderated after the rate cut announcement, debt markets, which are the source of the economic slowdown, remain unchanged. There is also concern that the efforts such as tax cuts by President Bush and Congress, will also do little to stimulate the debt markets. According to Mark Zandy, lead economist of Moody’s Economist.com, tax cuts and lower rates will only give policymakers more time to address the problem; however, they will not actually solve it.
In light of a possible looming recession, the Fed decided to take action before its upcoming meeting due to fears of greater dangers that could result from delayed action. With credit becoming harder to obtain, housing contraction worsening, and a worsening labor market, the early rate cut was intended to avoid a cycle of worldwide losses. The leaders from central bank have indicated that they are inclined to continue cutting rates as they deem necessary in the coming quarters.
Although Fed leaders justified the rate cut by applying conventional economic principle, the crisis in global financial markets is what prompted the Fed to react. According to Chairman Ben Bernanke, a decline in the stock market alone is not sufficient reason to cut interest rates. In this case, the decline in the stock market was viewed as a sign of declining confidence in the financial system, which is a legitimate reason for the Fed to take action.
While rate and tax cuts may boost confidence among companies and consumers, the debt markets remain unaffected. Containing the credit crunch is a struggle because many financial firms have invested in the housing market, and foreclosures are currently at record levels, thereby generating losses in many firms. This recession is more dangerous than others because it affects consumer and business spending. The Fed is particularly concerned with bond insurers who typically help municipalities and companies with weak credit borrow money. Bond insurers now must cover more losses than they can afford and some may be at risk of failing. New York insurance regulators are looking for ways to infuse new capital into the bond market for municipal bond insurance. As part of this effort, the New York State Insurance Department has convinced Warren Buffet’s company, Berkshire Hathaway, to enter the market for municipal bond insurance.
With the article "Fed Cuts Interest Rate to Stem Panic," the Washington Post Reports that, in order ward off a recession and prevent major stock market losses, the Federal Reserve cut interest rates on January 22nd by ¾ %, the largest such cut in 24 years. The immediate effect of this was stemming a drop in the stock market wherein the DJIA fell only 1.1% while Asian and European markets noted a 7% decrease (some of which was regained after the cut). It is also speculated that the Fed will issue another cut at during their upcoming regularly meeting. Debt markets remained unchanged after the announcement, which is discouraging because they are the primary cause of the concern.. According to Mark Zandy, lead economist of Moody’s Economist.com, tax cuts and lower rates will only give policymakers more time to address the problem; however, they will not actually solve it.
There is fear that this measure will serve only as a speed bump to the oncoming recession and that the fiscal policy pushed through by the president and congress will do little to aid as well. The Fed surprised everyone by taking action before its meeting, causing the action to be more effective, and justified this by noting that later action may not be sufficient to avoid a recession or combat fears over the housing market.
The consequence of a reduction in the discount rate is primarily two-fold: a drop in interest rates charged to banks when they borrow money from the fed, which in turn causes a drop in rates for consumers and businesses borrowing money and on existing adjustable-rate debts, including mortgages. The cut in rates also devalues the dollar which will help exporters. One possible long-term fallout of continued cuts is a loss of faith in the Fed to defend against inflation and maintain a rough value of the dollar. This would cause an outward shift in the Phillips curve and increase both unemployment and inflation.
My reaction to this article is appreciative in that it correctly and succinctly reports the news. Employing the hindsight of knowing that rates are further cut and that is has done little to combat the collapse caused by the subprime fallout.
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