Page 1 of 2 US rate cuts: Like a blow to the head
By Julian Delasantellis
Zhou Xiaochuan, the governor of the Bank of China, must sympathize with the
plight of poor Raoul, the waiter whose good service is rewarded with a brick to
the back of his head.
In a 2004 episode of the US cable network series The Sopranos , New
Jersey mafia boss Tony Soprano takes the senior leadership of his crime
family to an expensive dinner at a casino restaurant in Atlantic City, New
Jersey.
There they enjoy multiple rounds of the best cuts of steak, lobster and the
finest beverages; it is Tony's nephew and heir apparent, the sobriety-,
impulse-control-, fidelity- and literary-talent-
challenged would-be part-time Hollywood screenwriter and full-time thug
Christopher Moltisanti who gets stuck with the US$1,184 check.
Christopher is none too happy with this situation; he is particularly enraged
that his fellow goomba Paulie "Walnuts" Gualtieri sent over an
expensive bottle of Cristal to two young ladies he classified as "skanks" at an
adjoining table. He leaves a $16 tip, for an even $1,200. The waiter, Raoul, is
none too pleased with this, and he comes out to the parking lot to complain to
Christopher about his stinginess.
There was no problem with his service; he feels he deserves more. Standard
American tipping protocol calls for gratuities to amount to about 15% of the
check, which, in this case, would have called for a $177.60 tip.
Christopher is in no mood for interlocution. As in most scenes in The Sopranos
up to and including solemn religious observations, the situation rapidly
descends to exchanges of rank obscenities. As Raoul turns away to return to
work, Christopher throws a brick that hits the waiter in the head. As Raoul
writhes on the ground, unconscious in an epileptic-type fit, for good measure,
Paulie comes over, shoots and kills him.
I bet that, in the middle of the night Beijing time, after he became aware of
the results of Tuesday's meetings of the US Federal Reserve Board, Zhou
Xiaochuan, the man in charge of China's one and a half trillion dollars of
foreign exchange reserves, sympathized with the plight of poor Raoul. After
all, in deploying its foreign exchange reserves to buy US Treasury securities
to keep US interest rates low, and by not converting its US dollar export
proceeds into other currencies, China has served the US well.
And the thanks he gets is Fed chief Ben Bernanke hitting him on the head with a
brick.
In an extraordinary meeting of the United States Federal Reserve on Tuesday,
the board shocked the financial world (very much including me) by announcing
interest rate cuts far more extensive than previously expected. The expectation
was that the cuts would have been limited to just a single 0.25-percentage-point (25 basis
point) cut in the benchmark Federal Funds target rate; instead, the Fed reduced
the target rate 50 basis points, along with a second 50 basis point cut (the
first was on August 17) in a less commonly reported but possibly more important
rate that the Federal Reserve also controls, the Federal Reserve discount rate.
This is a complete rejection of the policy of former Fed chief Alan Greenspan
of slow and gradual interest rate changes so as to assure the markets that they
will not be continually surprised by unexpected Federal Reserve actions, a
policy that Bernanke had been maintaining during the previous 19 months of his
tenure.
The contrast between Tuesday's meeting result and the sunny optimism of the
previous Fed meeting on August 7 is breathtaking; it is far and away the most
ominous portent of the future prospects of the US economy since the current
"subprime crisis" broke into the market's consciousness earlier this year.
Comparing the results of the August meeting with Tuesday's is like going to the
doctor wanting to have a hangnail removed and having the physician start his
conversation by asking how you feel about cremation.
Clearly, this is an indication that the Fed feels that the surface calm that
has returned to world equity markets since the discount rate cut is illusory.
Contributing to this must be the actions by the Bank of England to once again
bail out the troubled Newcastle-based Northern Rock bank. A crisis that began
in the overheated condominium markets of southern California and Florida has
spread across the globe.
The fact that the Fed chose to lower both the funds and discount rates is
indicative of the uniquely serious nature of this crisis.
As I explained in my August 21 Asia Times Online article,
When the big guns fail, call in China, the
discount rate and the Federal Funds rate are two very separate monetary policy
instruments. The funds rate (lowered on Tuesday, for the first time in four
years, to 4.75%) is customarily the lower of the two; it governs the interest
paid by big banks when they initiate short-term lending and borrowing between
each other.
The Federal Reserve sets a "target" point for this rate; when they think that
the economy is growing too fast, threatening inflation, they raise the target,
as they did 17 times between 2004 and 2006. Likewise, when they are fearful of
an economic slowdown, they lower the target, as they did on Tuesday. The Fed
effects these target rate changes through either buying or selling Treasury
securities in its portfolio, to either provide or drain sufficient liquidity
from the system to move the market rate to the target rate.
The discount rate is always meant to be higher than the funds rate. This is the
rate at which the Federal Reserve will directly lend to banks shut out of the
private Federal funds market due to concerns about their soundness; it is
higher than the Federal Funds rate because the Fed wants to be available, but
not easy. Lowering the Fed Funds rate is the preferred policy choice when the
problem the Fed wants to address is feeling that there is generalized economic
weakness.
Discount window borrowing is considered the most effective tool for times such
as now, when certain banks and other financial institutions are being denied
access to Federal funds loans because of fears of their connection with the
subprime market. However, the Fed had already lowered the discount rate 50
basis points on August 17, to 5.75%. If they had lowered it another 50 basis
points without lowering the funds target, the funds target would have been even
with the discount rate, at 5.25%. So what we really saw on Tuesday was another
discount rate cut masked by a Federal Funds target rate cut.
To me, the most remarkable thing about these events is that they
demonstrate the breathtaking disregard that US economic policy makers have
regarding the value and fate of their own national currency. Richard Nixon-era
secretary of the treasury John Connolly, speaking to European economic
officials, once said that the US dollar was "our currency, but your problem".
The country could get away with that back in the early 1970s, when the US was
the world's biggest lender; now that this situation is reversed, and the
country must borrow $2-3 billion from foreigners each and every day just to
feed its overconsumption addiction.
The market reaction to this Fed move was about as expected as the day's sunrise
- a sharp fall in the US dollar. The greenback finally breached the record 1.4
level versus the euro; it has now fallen 15% against the euro since early 2006,
63% since early 2001.
Still, none of this had any effect on the drunken bacchanalia that erupted on
Wall Street following the announcement. The Dow Jones Industrial Average soared
336 points, 2.51%, to 13,739;
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