The Federal Reserve has once again taken markets by surprise by cutting interest rates by half a percentage point between official meetings of its committee.
The move sent stock markets, and particularly the technology-driven Nasdaq, significantly higher. It is the second time this year central bankers have reduced rates in an impromptu phone call weeks before their next scheduled meeting. The euro see-sawed as investors tried to decide whether the US rate cut was an alarmist overreaction that could ultimately hurt the dollar, or another shrewd move by US Fed chief Mr Alan Greenspan.
The dollar has benefited recently from the market's perception that the Fed is focusing on growth in marked contrast to the European Central Bank's (ECB's) concentration on containing inflation.
However, once the dust settles on yesterday's move, it is possible the markets will decide it was a panic action which might mean the Fed knows of some really bad news just around the corner.
However, the US central bank made a point yesterday of noting that the period between scheduled meetings was exceptionally long as the next meeting was not scheduled until May 15th, almost two months since the last meeting on March 20th.
US interest rates at 4.5 per cent are at their lowest in more than six years and are now below euro-zone rates.
Under normal circumstances, the higher return on euro assets would boost the currency. Quite how the currency will react over the coming days and weeks depends on whether the markets decide that the Fed's strategy is pro-growth and whether that is preferable to the ECB's approach.
According to Dr Dan McLaughlin, chief economist at Bank of Ireland, the euro is now likely to fall to $0.85 and could fall even lower if the ECB does not move at its next meeting.
The Fed made it very clear in yesterday' statement that promoting growth was its main motivation for the rate cut. It pointed to falling capital investment and corporate profitability as well as uncertainty about the business outlook. This, combined with the likely slowdown in consumer spending as a result of falling equity markets, "threatens to keep the pace of economic activity unacceptably weak".
The key is that the Fed targets price stability and sustainable economic growth, and it warned yesterday that the risks are weighted mainly towards conditions that may generate economic weakness in the foreseeable future. The rate cut also suggests Fed policy makers are concerned the slowdown may be more prolonged than they earlier expected, threatening the record economic expansion, now in its 11th year. The consensus is that the US economy grew by around 1 per cent in the first three months of the year, compared with an estimate of its potential of around 3.5 per cent.
The latest rate cut is not likely to boost growth immediately, nor will it mean the end of the stream of profit warnings from US firms, particularly in the technology sector. However, it could be enough to start to boost business spending and hence confidence which could mark the end of the downturn.
In contrast, speaking earlier this week, Bundesbank president Mr Ernest Welteke pointed to growth of around 2 per cent this year in the euro zone, revised down from a previous estimate of 3 per cent. Nevertheless, he implied that the risks to inflation mean that no rate cut was being contemplated.
Mr Welteke and the rest of the ECB board members are now likely to come under increasing pressure for a rate cut, although to date it has ignored all such pressure from either the markets or the US authorities.
