The stock market in India has been making new this week, for a change for all the wrong reasons. The world markets are down and there was a quick solution required. The Fed responded by cutting the interest rate by 75 basis points and the markets responded by coming back to the green zone again. So, was it all this easy? Why wasn't it done earlier? Let's evaluate.
In the US, although the economy has grown, jobs have increased and productivity is higher, things are not as good as they seem. Currently there are three negative effects happening.
1. The oil prices are sky rocketing
2. the sub prime mess has left people feeling poor as the value of their assets (homes) has gone down. The sub-prime mess has also extracted the liquidity from the market.
3. The dollar devaluation
How did sub-prime extract liquidity? Who really lost the money?
When the times were good, the banks and other financial institutions offered loans to people to build their homes. China was also investing in real assets in US which made the realty market heat up. China maintains its currency at a certain level viz a viz the dollar because to keep its exports attractive to US. If Chinese currency appreciates then US consumers will need more dollars to buy the same good and hence make it unattractive. Therefore, China buys a lots of dollars hence creating an artificial demand for it and appreciating the price. Then China buys real assets in US with these dollars.
Now, when real estate was sky rocketing, banks offered loans to people even with lower credit scores. Why did the bank do that? They did it because they could charge a higher interest rate to cover for the extra risk they were taking. People found it attractive because now they could own homes and with the property prices going high, the value of their asset would go up. They could then refinance the loan at lower rates and pay off the higher interest rate mortgage that they originally took. On top of that, the banks offered lower interest rate for first two years and higher interest rate for period after that. The later interest rate would readjust based on certain factors. This gives enough time for the mortgage buyer to improve its credit score, and in the mean time the house prices will also go up. This was a nice business and many people took loans. This increased the demand for the houses and hence heated up the realty sector even further.
Now, banks couldn't keep so much debt on their balance sheets. They therefore, securities these loans and sold them to other financial institutions and hedge funds. These securities are like bonds with future payments coming from the mortgage payments. These securities were also categorized into higher, medium and low risk. These securities were then traded and there was an attractive market for these securities. There was another agency for the rating of these securities which for some reason, rated these securities as high and totally ignored the risk. The banks who didn't have these loans on their books were now safe. Since their incentive was linked to selling more of these loans, they blinded themselves and bypassed any due diligence.
The business kept on going, unless one day the bubble burst. The home market started declining. This meant when the higher interest rate period came, the home owners were not able to refinance it, as the value of their asset had gone down. They started defaulting on their payments. The banks were forced to carry out the foreclosure of loans and put up the house for sale. This now had a negative effect. The supply of homes became higher and prices went further south. This causes many more to default on their payments and more fore closures happening. All the money was used up in building houses. The ultimate loss was for the hedge funds and financial institutions like Citibank and Merill Lynch who bought the Mortgage Backed Securities.
Why recession?
Now, there was a liquidity crunch as explained above. There was no money available for companies to invest and grow their business. If business will not grow then there would be no jobs created. Therefore, the Fed decreased the interest rates. Ideally when the interest rates go down, people have less incentive to save and they increase their consumption. Companies can borrow cheap money to invest in their business. This makes economy do better and the consumption goes up. However, the down side is that the inflation goes up too because of increased supply of the money. Fed obviously does not want the inflation to go up. Therefore, it can not keep on decreasing the interest rates.
Even the Oil prices are high. The crude has gone up to almost $100 per barrel. The gasoline is selling for $3 per gallon right now and any increase to $4 will impact consumer spending a lot. People are already battling with low house prices, and high prices with added inflation will cause the consumer spending to go down a lot, taking the economy into a recession. Most experts are divided right now as to US will hit a recession or not. Some predict a recession and some predict a slow growth rate for 1st half of 2008 with economy rebounding in the second half. Most depends on where the housing prices stabilize. If housing prices go down further, the sub-prime mess will get deeper, further reducing liquidity in the market. However, by reducing the interest rates, the Fed is helping because the interest rate for mortgage are determined from the base rate and if the base rate goes down, the subsequent rate will also go down and some foreclosures may be saved. However, most will depend on the overall housing prices.
China Factor
As mentioned above, China has kept its currency stable artificially by buying dollars. However, this also causes inflation in China. To buy dollars, China has to print more money and more money means higher inflation. This inflation has caused the prices go up very high. At the same time, China unquenchable thirst for Oil and Commodities like metals had caused a worldwide boom in prices. Now, China is in a precarious position and taking steps to cool down its economy. Any decrease in demand by China in oil and commodities will cause these prices to cool off a little bit and should help US avoid recession.
Dollar Devaluation
Fed has been cutting interest rates to add some steam to the economy. However, these rate cuts also make the investments in US Treasuries unattractive. Most people/investors/countries have option to invest their money somewhere else. With US Treasuries less in demand, the dollars to buy these treasuries is also less in demand. This decreases the valuation of the dollar. Lesser dollar value means US has to spend more to buy oil and hence adds to its recession. However, the good news is that weaker dollar will help US exports, discourage Chinese imports, encourage domestic consumption. Higher domestic oil prices may reduce demand for oil and hence bring down the world price for crude.
Summary
In summary, US recession seems eminent. There might be some probability that the turn of events and Fed's actions save it and reverse the trend, but until US savings rates go up, the economy seems to be going into a state of stagflation.
