Let us understand the effect of Fed rate cut on US economy. But before that lets us understand what is Fed rate. Fed rate is the rate of interest at which US banks can borrow form each other. For example if one bank is facing temporary shortage of money to fulfill its reserve requirements it can borrow form other banks at this rate. Fed rate is also an important bench mark which decides the lending rate in the US economy. Something similar to our PLR.
By cutting Fed rate the Federal bank want to ensure that the short term lending rate declines in order to stimulate the short term demand in the US economy in order to save US from recession. As lower rate will induce people to borrow and spend more.
More importantly Fed is cutting rates to stem the current wave of foreclosures in US housing markets and to save the US financial institutions form going default because of the loss form sub-prime mortgages. Because of decrease in Fed rate the Housing loans EMI will reduce and more people will be able to afford to make payments and this will result into decrease in housing foreclosures.
Now here a question arises that the Fed had cut rate form 5.25% to 3.00% and still the loss form housing foreclosures had increased manifold instead of decreasing as per the argument. The reason behind this is that monetary policy has lag effect on economy. It will take 6 months or even 9 months for the effect of a rate cut to filter into economy and to kick start the process. But during this time the pain is inevitable. Although there is a huge fear of inflation going out of control I support the decision of Fed to cut rates to save the financial world form getting into Chaos. The effect of a big institution in US going default on the world economy is unimaginable. It may create a global turmoil which may take years to get shorted and the entire global financial system is at a grave risk of breaking down. Compared to this the risk of inflation although great is not as grave as risk of Financial system breaking down.
Although I believe that because of present cut in Fed rates the situation of housing markets will improve form here in next coming 6 -9 months but unlike the previous time fed may not be able to save US economy form recession. The only effect of Fed rate cut is that Fed will be able to save the financial institution and financial system form breaking down.
Before exploring into the reasons why the Fed won’t be able to save US form recession just like other times I would like to give you a brief facts sheet about US economy.
1. The US GDP is around 13 trillion US dollars.
2. The US GDP constitutes 20% of the Global GDP.
3. US population is around 220 million people which is roughly around 3.5% of global population.
4. US consumes around 48% of Global natural resources.
5. US is the largest borrower in the world. It borrows around 700- 800 billion dollar annually.
6. US consumes 22 million barrels of crude oil daily which is roughly 25% of global production.
Here we can clearly see reason for the affluence of Americans, 3.5% people of the world are consuming 48% of global natural resources and 20% of global GDP is dependent on them, and they are sustaining their higher standard of leaving by borrowing form the world. In order to consume more and more they keep on printing US dollars and the world accepts that value in each new dollar which is being printed.
I will give you a small example to make things clear. There is small village with only one shop keeper (representing the rest of world) who produces and sells all the goods and services. And there is only one wealthy man who buys all the goods and services produced. Now what is happening here is that the shop keeper has to sell its goods and services and there is no buyer expect that one person. So if that person don’t have cash to pay for Goods and services the shop keeper lends him money so that he can afford to buy those goods. This way wealthy man is able to consume the goods by only giving a promise (in the form of Debt) to pay in future.
This is a big paradox. Because the Wealthy mans ability to repay his debt is limited and sooner or latter the shop keeper will realize that this wealthy man will not be able to repay him and he will stop giving loans to him and he will stop consuming there by reducing his standard of living.
This is what is happening on the global scenario. Sooner rather than latter people will realize that US ability to repay the loans is limited and they won’t give them cheaper loans. The US will have to pay high rate of interest in order to take loans, so they will take less loan and decrease their consumption which will put their economy into recession. Or they will have to increase their exports and falling value of Dollars is good for their export sector as it will make their goods and services more competitive.
Other factors affecting this problem is because of recent large losses because of sub prime the US banks has tightened their lending standards. The cheap credit which was driving the consumption and the economy is not available any more. Moreover the banks have seen considerable erosion in their capital which has limited their ability to take risk and make riskier loans. There has been a complete change in the lending mentality of institutions which are now afraid to make loans to people of questionable credit, so we will see a period of credit contraction which will again lead to a recession in US economy.
What I believe is that recession in US economy is not bad for long term health of global economy. We all know that the world have been excessively dependent on US consumption for growth. The result of it was the US citizen was experiencing a higher standard of living compared to the citizen of country which was producing all the goods and services but was still experiencing a low standard of living. The result of prolong US recession is that the US GDP as percentage of Global GDP will decrease. This will give an opportunity for rest of the world improve the living standards in their own country if they focus more on internal consumption or export to other nation. All thought this sounds very smooth but the adjustment in global pattern of consumption isn’t going to be smooth. The US won’t accept a low standard of living for its citizen and it will do everything possible to preserve its status in the world. It will also be hard for other countries to believe in their own potential and stop looking at US for world growth. There are many assumptions which goes into my conclusion and the most important of them is the Global GDP will still continue to expand and grow inspite of a US recession. I believe this assumption will hold good as more than 60% of global growth is driven by two countries India and China.
BigGains !!
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