Unlike most countries' central banks, The Fed, or the central bank in US is not government controlled. From Wikipedia, The Federal Reserve is:
The Federal Reserve System (also the Federal Reserve; informally The Fed) is the central banking system of the United States. Created in 1913 by the enactment of the Federal Reserve Act, it is a quasi-public (part private, part government) banking system[1] composed of (1) the presidentially-appointed Board of Governors of the Federal Reserve System in Washington, D.C.; (2) the Federal Open Market Committee; (3) 12 regional Federal Reserve Banks located in major cities throughout the nation acting as fiscal agents for the U.S. Treasury, each with its own nine-member board of directors; (4) numerous private U.S. member banks, which subscribe to required amounts of non-transferable stock in their regional Federal Reserve Banks; and (5) various advisory councils. Currently, Ben Bernanke serves as the Chairman of the Board of Governors of the Federal Reserve System.
If you look at point 4, a lot of private banks are a part of Fed and they control most of the decisions. At the same time, these private banks control over 75% of Fortune 500 stocks. So, is there a conflict of interest?
It could be argued that these banks would like the stock markets to zoom. Given the happenings in the market in the last month, the argument seems credible. The argument goes, that by cutting the Fed rate, there is less incentive for the US consumers to save and they will have two options:
1. Increase their spending.
2. Invest in other higher risk instruments like stocks.
By increasing the spending, the US companies will have higher revenue and will help their stock prices. And by investing in stocks, the cost of capital for these companies will go down as more people will want to invest in stocks and that will also help the Wall Street. The Fed expects this to provide impetus to the economy and help US come of out recession, or rather avoid it. Whether, this is a good way to help economy is arguable because economic theory suggests that lower interest rates lead to more supply of money in the system (as people do not save it in banks) and leads to inflation. Higher inflation, higher commodity prices means curse for the end users. They will want to borrow more, given the lower interest rates, but with sub-prime ghost still looming finding credit will be difficult and economy may come to a stand still again.
Inflation or Deflation?
My friend, Pratap, argues that the lower interest rates will make more money available to the consumers. However, they will not spend because given the current economic conditions people will not want to spend but will want to keep it for a rainy day. Jobs are decreasing (http://in.rediff.com/money/2008/feb/02us.htm), so people do not want to splurge yet. They have recently burnt fingers by investing in high risk assets (the whole starting point of subprime crisis), so they will be wary of investing in stock markets too. What they will most probably do is to use the money to settle the debt. With interest rates lower and subprime rate being calculated over that, people will have incentive to pay back the debt at lower rates and excess money supply.
The power of currency comes from the fact that, when a $100 is put in the bank, the bank lends the same to someone else, who will put $80 is the bank, which the bank will lend again and so on. So, the real liquidity of one $100 is much more than a $100. This is the money multiplier effect. So, if people start paying off the debt, the money multiplier effect will decrease because banks will not be able to lend the money as easily now. This will decrease liquidity and cause deflation.
Also, the commodity prices will decrease if US economy slows down. The demand for oil and other commodity like Iron Ore, Coal etc will decrease thus decreasing prices and hence causing further deflation. This will cause the dollar to remain strong and not go down further.
My argument against this reasoning is that, the assumption here is that that markets for US companies are all domestic. When fed dropped the rates, dollar becomes weaker because of excess supply. Also, the commodity prices have downward pressure because of lesser demand from China as was argument in my earlier post. This will decrease raw material cost for US, and make exports attractive. Rest of the world, will want to import from US because they can buy more for the same amount of their own currency that they will spend. China is purposely slowing down and this will also help US exports. This increased competitiveness may cause US economy to come out of recessions, increased jobs, better wall street profits, causing people to invest more, spend more and save more.
What will happen is anybody's guess.
Impact on India
Strong dollar is good news for India. So, if by any of the above arguments the dollar does remain strong, the Indian exports will do well. Also, the lower commodity prices especially oil will help Indian imports and will make Indian manufacturing exports competitive. India might be able to siege some initiative from China though it is light years away from catching up with China. India can also benefit by importing technology and machinery from US or by buying assets in the US. Indian companies can look at acquiring some US companies with a stronger rupee right now.
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