Behind the Fed's rate cut

The US Federal Reserve Board has done the expected, and dropped the federal funds rate by 25 basis points, to 4.50 per cent. It has also said that there will be no further rate cut at its next meeting in December. The currency market has responded immediately, and the dollar has fallen against both the euro and the pound. There may now be further upward pressure on the rupee. The Reserve Bank's attempt to tighten liquidity in the domestic market by sucking out Rs 15,000 crore through a higher cash reserve ratio to be observed by banks may not therefore have any lasting impact, as ICICI Bank's KV Kamath said in Bangalore yesterday. Interest rates may soften as a result, contrary to the RBI's wish.

Beyond the reactions of, and the outlook for, the markets, there are two sets of factors worth noting. One concerns the prospects for the US economy in 2008. The GDP data continue to show respectable growth rates, but consumer confidence is at a two-year low, and the news from the housing market has got worse, with more mortgage foreclosures and a downturn in housing prices that is said to be the worst since 1991. Among other things, this must mean that the availability of credit too will deteriorate. Corporate results have not been encouraging, and the expectation seems to be that the cheaper currency is not going to do enough to ward off an economic downturn. Don't be surprised if the Fed is forced to resume interest rate cuts early in the new calendar year.

The second issue is the fall of the dollar, and not just against other currencies. Whether it is metals, agricultural commodities, oil, or a variety of assets ranging from real estate to gold and stocks, the global story is of price inflation in dollar terms "" indeed, the global liquidity surge is another way of saying that far too many dollars have been printed in recent years, to pay for American imports. If excess supply of the dollar means that it is not safe any more as a store of value "" which is one of the fundamental functions of any currency, and especially so in the case of a reserve currency "" then markets will start looking for alternatives. The euro offers a choice that was not there in an earlier era. Investors may also be looking at gold, whose price in dollar terms has risen by nearly 150 per cent in the last six years. If the Fed is forced in 2008 to cut interest rates further in order to ward off a recession, then the dollar could end up being at least partially dethroned as central banks and all the others who have been confident buyers of US treasury paper start looking at options rather more seriously than they have in recent years.

While it would be hugely premature to suggest that the decline of the dollar presages a change in the relative dominance of the US economy itself "" for it remains by far the biggest and most powerful and among the most dynamic systems around "" the theory of 'decoupling' that has gained currency in recent weeks is a pointer to the growing importance of other, more rapidly growing economies. The chairman of General Electric, for instance, was quoted earlier this week as saying that any decline in his company's US business would be made up by the growth of its business in China and India. No major chairman of a US corporation could have said that a decade ago.