The US Federal Reserve's most recent cut in interest rates was greeted with a little disappointment in some quarters. Several commentators had been hoping for another 50 basis points cut instead of the more modest cut of 25 basis points, which brings the Fed funds rate down to 3.75 per cent. Financial markets reacted with equanimity to this move. The prices of long-term US government bonds rose modestly as bond investors took the view that the slower pace of interest rate declines would be good for long-term inflationary expectations.
Equity market sentiment continues to be driven by news on corporate profits and there is little sign of any improvement in this regard. If anything, the slide in corporate profitability has much further to run before a bottom is reached.
Nevertheless, once the news from the Fed was digested, this small reduction in interest rates seemed to have a marginally positive impact on equity markets. The statement accompanying the announcement indicated bias of policy still remains towards further monetary easing. Indeed if the cumulative decline of 275 basis points in the Fed funds rate fails to stimulate the US economy by the third quarter, a further decline towards a 3 per cent Fed funds rate could well occur.
As the table shows, US interest rates are now substantially below those in the euro zone. Recent comments from board members of the European Central Bank (ECB) suggested that there has been some softening in their stance. The euro-zone inflation rate remains stubbornly above 3 per cent compared with the ECB target of a long-term rate of 2 per cent.
However, economic forecasters see increasing evidence that euro-zone inflation will fall sharply towards the 2 per cent level by year-end. Unfortunately, confidence that this will occur is due to recent economic data, which suggests the big economies of Germany and Italy could slip into recession later this year. In such circumstances, the ECB would be forced to cut euro rates.
Nevertheless, it does seem likely that the Fed will remain more aggressive than the ECB in terms of interest rate reductions and US interest rates are likely to remain below euro rates for the foreseeable future.
For comparison, the table sets out current rates of interest in Japan. Short-term rates are effectively zero and even the yield on the 10-year bond is barely above 1 per cent. The Japanese economy has endured 10 years of slow to stagnant economic growth. The economy is suffering from an enormous hangover post the "bubble" economy of the late 1980s.
The Japanese experience epitomises the Federal Reserve's worst nightmare - a prolonged period of deflation. The fundamental underlying problem besetting Japan is weak consumer demand. Demand within the economy is simply not sufficient to keep the country's businesses and factories busy. This has meant businesses have had problems servicing their debts and the Japanese banking system has been quagmired under a mountain of bad debts.
So far this year, consumer demand in the US, which accounts for the lion's share of demand, has been the only bright spot in the US economy. Indicators of consumer confidence remain steady and clearly the Fed is hoping that its policy of aggressive interest cuts will shore up confidence.
Further reductions in US short-term interest rates combined with George Bush's tax-rebate scheme should be sufficient to at least stabilise the US economy in the second half and generate a modest rebound going into 2002. The US authorities still have plenty of scope to stimulate economic activity and the example of Japan's experience suggests that the Fed and the Bush administration will err on the side of over-stimulation rather than risk an economic slump.
