The most important ramification of the Fed's expected decision to hold rates next Tuesday is that it will put off a desperately needed growth-inducing ECB rate cut.
Analysts and investors alike will remain at their desks late into the evening next Tuesday, as they await an announcement on interest rates from the Federal Reserve, the American Central Bank.
Some analysts are anticipating that the Fed will cut interest rates in an effort to re-ignite the faltering US economic recovery. Equity investors are hoping that they do, because a rate cut would indirectly bolster stocks globally. However, I'm afraid they will be disappointed. I do not believe the Fed will take monetary action next Tuesday. And that decision will affect us all.
The Fed certainly could make a case for cutting rates next week if it so chose. Recent economic releases in the US have been far from strong. Unemployment remains stubbornly high as cautious businesses withhold investment, fearing that a fall-off in consumer spending would result from the loss of wealth caused by the equity market's downturn. Consumer confidence is at its lowest level since last September. Manufacturers recently reported that new orders had fallen for the first time in seven months. And gross domestic product (GDP) in the US collapsed to record only 0.3 per cent growth in the second quarter (non-annualised).
Yet I think the Fed will hold fire next week. Firstly, the threat of military action in Iraq will dissuade the Fed from cutting rates now. With US rates already at 40-year lows of 1.75 per cent, both the market and the Fed knows that only one more rate cut will have any real impact on economic conditions. It is the last piece of monetary ammunition with which to react to crisis, the last role of the dice to stave off recession.
So the question the Fed must ask itself next Tuesday is simple: have economic conditions deteriorated sufficiently in the past month to merit risking the final possible US rate cut? Or is there a risk that a protracted military campaign in the Middle East will knock the US economy back into recession, and should the last rate cut be kept in reserve to cope with that eventuality?
Such a scenario is more plausible than many in the market choose to believe. For one, estimates place the cost of military action between $100 billion and $200 billion (€103 billion-€106 billion). As yet it's unclear what proportion of the cost might be met by the US.
However, the US federal budget is already in deficit, due to falling tax revenues and excessive government spending. Facing a deficit in excess of $150 billion for the year to date, the US can ill-afford the cost of a war now. The Fed will want to keep its last rate cut in reserve, to revitalise the economy, should such expense ultimately stifle growth.
There is also a real risk that a prolonged campaign could see the price of oil rise, for a protracted period. Disruptions to supply from Iraq may not be of concern, yet any fall-off in Saudi supplies resulting from the conflict spreading would send oil much higher.
A $5 rise in the cost of a barrel of oil, if sustained for a year, is estimated to reduce world output by 0.25 per cent. And the sustained rise in the cost of oil caused by the last Gulf War contributed to the last US recession.
If such events were to transpire, the Fed would want to have a rate cut in reserve to attempt to counteract a slide back into recession, and salvage consumer confidence.
And finally, despite recent data highlighting just how tentative the US recovery is, even bearish forecasters estimate that the US will record GDP growth of upwards of 2 per cent this year.
The housing market remains strong, and retail sales, although supported by discounting from car manufacturers, show encouraging signs. A growth rate of over 2 per cent should be seen as acceptable given current market circumstances.
Were the Fed to proceed with a rate cut now, interest rates in the US would fall to levels not seen since 1958. In that year, US GDP contracted by 1 per cent. Rates lower than current levels are commensurate with recessions, not with moderate growth. If the Fed were to lower rates now, it would leave itself open to accusations of over-reacting to recent data. The Fed has been guilty of exacerbating market cycles in the past (for example, cutting rates and driving equities higher when market prices were already "irrationally exuberant" in Fed chairman Greenspan's opinion). While it espouses pre-emptive action to avert recession, it will be fully cognisant that greater risks lie in the months ahead.
The Fed will keep its last rate cut in reserve for such an eventuality, and allow time for its 11 rate cuts in the past 12 months to fully take effect.
If the future were not so uncertain, the Fed would react to recent signs of weakness by lowering the cost of funds. Yet if my forecast is correct, no change on Tuesday may well see a sell-off in global equity markets next week, led by a fall in the Dow. That is likely to be the first way we will notice the impact of their decision.
And if the Fed does not initiate another round of global interest rate cuts, it is highly unlikely that the European Central Bank will act autonomously and cut euro-zone interest rates at all in 2002. This is the most important ramification of next Tuesday's expected decision for us: we desperately need a growth-inducing rate cut in the euro zone, yet without the US taking the initiative, such a cut may not occur.
Niall Dunne is an economist with Ulster Bank Financial Markets
