Is the U.S. Fed Running Out of Options?

Only a few days ago the U.S. Federal Reserve and numerous government officials started acknowledging that the US economy could be falling into recession. In one hand, the U.S. government has been implementing several measures to soften the crisis. On the other hand, the U.S. Federal Reserve has been trying to tackle the recession monster by cutting interest rates and using liquidity injections.

In fact, since last August, short term interest rates declined by 225 basis points and another big cut of 100 basis points is expected on March 18. In addition, since December, the Fed has been offering $20bn of 28-day loans, increased to $30bn in January and to $50bn a few days later. Two weeks ago it announced another $100bn of term liquidity and last week it started offering to lend up to $200bn of Treasury bonds in exchange for triple-A mortgage-backed bonds.

However, the monetary policy has not been effective and we think the Federal Reserve may be running out of options. This could be mean bad news for the U.S. dollar and make stocks fall even further. In the past, each time the Fed was cutting rates, the euphonium lasted only for a few hours, and then the financial markets were going back to the same if not the lower level. What’s more, the several rate cuts haven't brought any effect for the already indebted households. In fact the long term interest rates went up and banks became less reluctant to lend money. Moreover, it has been suggested that cutting interest rates further would only push inflation expectations higher and cause sharp increase in nominal interest rates. It is also likely that bond prices would crash and a short financial crisis would become a long one.

Anna Fedec,
3/17/2008 1:30:12 PM