What next for the Fed...


One of the main function of the Federal Reserve is to adjust the interest rate according to current economic conditions. The members of the Fed get together on a regular basis, the first and third Monday of the month, unless they call for an emergency meeting, to decide if the discount rate should be changed or not. Since the 10th of May 2006, the discount rate has dropped from 6% right down to 2.25%(as at 1st of May 2008). There is no argument as to why the Fed had to decrease the rate at such a drastic level, but one big problem the Fed has to face now is the continuous rise in inflation and the slowing down of the America economy, in other words, stagflation has arrived.

On the one hand, the price of oil and food are rising non-stop. On the other, because of the credit crunch, lending has tightened and with confidence declining, investments will decrease and so will growth. The problem with changing the discount rate right now is that, there will always be a trade-off no matter what the Fed do. That is, if they decide to increase the rate, inflation should be checked and held at the same level for sometime, but the future of the economy will be even gloomier. But if the Fed opts for the alternative and decide to decrease the discount rate, inflation will rise even further. All this comes down to one question, what is the main concern for the central bank?

The European Central Bank's(ECB) priority was never in doubt, they decided that containing inflation is their main objective right from the beginning, that is why they never lowered their interest rate during the credit crisis. Of course, they had an advantage over the Fed, and that is the credit crunch didn't spread as much as they did in America, hence they only had to deal with the rise in prices of commodities. But as time goes on, Europe is starting to feel their economy slowing down, some odd countries are still maintaining high level of growth, like Germany, but the growth is slowing down as well. One big difference for the ECB, compared to the Fed, is that their interest rate is the same for all the members of the Euro. This means that even though some countries might be experiencing higher unemployment and lower growth than others, they will have to settle with the same interest rate and hence might not be as helpful if the interest rate is decided for that particular country.

Now back to the Fed, with the discount rate as low as it is right now, the US dollar is consequently low as well. This means that Americans will have to spend more than before to buy the same item. This is because, although low dollar means that American exports will be relatively cheaper, which should help curb the current account deficit as the amount of exports increase, imports will be more expensive than before and this is one of the reasons why inflation is getting higher. One might ask, "if imports are getting more expensive, won't that lower demand level?". The answer to that is yes, it will. But since Americans consume more than they could produce, in the case of oil and food and other commodities, they have no other options but to pay more to meet their needs. To counter this problem, the Fed can raise rates so that the dollar will rise again, compared to the other currencies, so things will be cheaper for the consumers. A downside to this though, as talked about earlier, is that increasing the rate will decrease borrowings and hence investments. With many people suggesting that the American economy is already recession, higher rates will only make the matter worse. Even though the rate at present is very low already, as a matter of fact, even lower than the rate of inflation. This means that even if I put money into my savings account, the interest I gain is still not enough to compensate for the higher price of the goods and services I consume.

If, however, the Fed decide that avoiding recession is a much more important issue, they might decide to maintain the discount rate at the current level or even lower it, which is highly unlikely. Given that most of the inflation is caused by oil and food, and the core inflation(inflation rate excluding oil and food lol) is actually quite stable, the Fed can bank on the fact that the rise in prices for oil and food is only temporary(this is supported by a lot of analysts, even by the newspaper I read). Even though the rise of price for oil and food is only for the short term, it doesn't mean there will be no harmful effects for consumers. Assuming that the Fed decided not to change the rate, inflation will definitely rise continuously as a result. This means that consumers will expect higher inflation in the future and therefore pursue for higher pay from their employers. Even if these businesses can pay higher wages, they will have to somehow pass on the extra costs to consumers, and the spiral goes on.

If we look back at the 1970s, we can see that the price of oil was rising non-stop, but after a while, the price started to drop again. This time however, is a bit different than the 70s, and that is the rise in demand of oil and commodities are mainly driven by the emerging countries like China and India and we also can expect that their demand will not curb as quickly as we might hope for. We also know from recent history(the dot-com bubble in 2001 and the crash of the Asian markets in 1997) that it takes a few years before an economy can recover to the state before the crisis, in this case, the credit crunch. Of course, we have to also consider the fact that the emerging markets are now relying less on the American economy, unlike those scenarios before, when the American economy represented the world economy. The chairman of the Fed, Ben Bernanke has suggested that there could be a possibility the discount rate will be raised at the end of this year, and we deduct from this that the Fed is trying to avoid both recession and inflation at the same time. It remains to be seen how much and how many times they will raise the rate, but the most important thing is that the ECB and the Fed should act in a coordinated fashion. This is because if the Fed chooses to avoid recession over inflation and the ECB decided to raise interest rates, the US economy will surely face even higher inflation, and things might start to get out of hand.